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Putting real estate inside a corporation sounds sexy. Hall Capital INCORPORATED sounds so much cooler than Hall Capital LLC. I completely understand why real estate investors get jazzed up when they hear about such an entity structure.
Our clients usually come to us with questions regarding real estate and corporations after they've attended a real estate meetup or guru event. And it's great that whatever they heard excites them about taxes enough to talk to me. But it's always a huge let down for the client when I show them how often bad advice floats around those events.
No one should ever put rental real estate inside a corporation. Ever.
Sounds pretty extreme right? Heck, the tax code is so convoluted that there must be an exception somewhere, right? Nope, absolutely not. Rental real estate should never be placed inside a corporation.
Buckle up because you're about to hear the laundry list of reasons I give to any client considering placing rental real estate inside an S-Corporation or a C-Corporation.
Purchasing and Operating Rental Real Estate in a Corporation
The actual purchase and operation of real estate inside a corporation really isn't all that bad. You're just stuck with real estate inside of a corporation. For the most part, operating the real estate inside the corporation doesn't come with many pitfalls during the hold period.
There are some downsides to the use of a corporation for your rental real estate. Your corporation will have more stringent reporting requirements than an LLC. You will also have tax planning issues down the road due to the loss of flexibility that corporations are known to cause.
But hey, day-to-day you'll hardly notice a difference.
The real problems will arise when you want to take the property out of the corporation. Moving property out of a corporation causes a tax event as we'll discuss later. This is an issue for anyone holding real estate inside of a corporation but especially for those who have "partners" owning shares of the corporation.
Related: Cons to Consider when Using an LLC
Transferring Rental Real Estate into a Corporation may be Taxable
There are many cases where investors and business owners may feel the need to transfer real estate into a corporation. Maybe they are forming a new partnership and all partners are contributing property. Or maybe they just think the idea of a corporation holding their real estate is sexy (it's not).
If you ever decide to transfer rental real estate into a corporation, you'll have to be aware of several potential issues.
The first issue is that transferring appreciated real estate into a corporation causes the transferor to recognize capital gain. The capital gain is the difference between the fair market value and the tax basis of the property. Remember, tax basis = cost + improvements - accumulated depreciation.
There is one exception to this rule that allows the taxpayer to transfer real estate into a corporation without having to recognize capital gain. In order to qualify for the capital gain recognition exception, the taxpayer must control the corporation immediately after the transfer of real estate. "Control" in this case is defined as owning 80% of the corporation's stock immediately after the transfer.
"Control" can also apply to groups. You don't need to own 80% of the corporation on your own immediately after the transfer of appreciated property. As long as another person or persons transfer appreciated property to the corporation at the same time as you, and your combined interest in the corporation exceeds 80%, then you control the corporation as a "group." This means that if you and a partner decide to each contribute property to a newly formed corporation in exchange for 50/50 ownership, you won't have to recognize gain on your appreciated real estate.
When you qualify for the control exception, the capital gain doesn't disappear. Instead, your share value of the corporation stock will be equal to the tax basis of the contributed property. So whenever you decide to sell the property or the corporation stock, beware of the large gain that awaits you.
Additionally, if the property being transferred into the corporation is subject to a liability, as is the case with most real estate, we have more problems. If the corporation assumes the liability from the transferor, then the transfer will trigger gain in the amount that the liability exceeds the tax basis of the asset.
But here's the kicker: gain on debt relief occurs whether or not the taxpayer qualifies for the "control" exception above. Be wary of transferring any real estate into a corporation.
Transferring Rental Real Estate out of a Corporation is Taxable
Moving real estate into a corporation is the easy part and may not have immediately noticeable tax consequences. It's getting real estate out of a corporation that's difficult. This is where working with a rock solid real estate CPA comes in handy. We know that we need to plan for the liquidation of your real estate now, not 20 years down the line.
Unfortunately, advisors and attorneys who recommend corporations for rental real estate don't have the foresight to understand the future negative consequences. What happens when your partnership ends? What if you want to move the real estate out of the corporation for estate planning purposes? What if you pass away and you still have your rental real estate inside of a corporation?
If a C-Corporation sells appreciated real estate, the corporation will pay a corporate tax, now a flat 21%, on the gain. And yet, the money is still in the corporation. In order to get it out, the owners must pay another tax on the distribution. If the distribution is non-liquidating, meaning the corporation is still in operation post-distribution, then the owners pay a tax on the dividend income up to 23.8%. If the distribution of cash is liquidating, meaning the corporation ceases to exist, then the owners would recognize capital gain for the difference between the amount distributed to them and their basis in the corporation's stock.
Either way, selling appreciated real estate within a corporation produces huge tax inefficiencies for the owners.
Recognizing these inefficiencies, some investors will opt to simply transfer the real estate out of the corporation rather than sell it. But of course, nothing is as easy as it seems when it comes to the tax code.
When you transfer property within a corporation to owners, you will have either a current distribution (non-liquidating) or a liquidating distribution.
With a current distribution, the corporation will treat the transfer as if the corporation sold the property at the fair market value. This means that the corporation will pay tax on the capital gain as if the property was sold outright.
A liquidating distribution is a bit different but results in just as bad tax consequences. The corporation will again treat the transfer as if the property was sold and will pay tax on the resulting gain. But because the corporation has ceased to exist, the owners will also recognize gain on the difference between the fair market value of the property received less liabilities assumed by the owner and the owner's basis in the corporation's shares.
The same rules apply with S-Corporations except for the fact that an S-Corporation is a pass-through entity. As a result, an S-Corporation is not subject to the double taxation that a C-Corporation is. While an S-Corporation wouldn't have to pay tax twice to get real estate out of the corporation, it still can't move property out of the corporation without triggering a sale.
LLCs are More Flexible than Corporations
Partnerships provide much more flexibility when it comes to owning rental real estate. This is why you will often hear investors using LLCs when discussing entity structuring.
Transferring appreciated real estate into a partnership is simple and doesn't come with tax consequences. Unlike corporations where you must control 80% of the corporation immediately after the transfer to avoid recognizing capital gain, with a partnership, no such rule exists. You could contribute a property with a huge built-in-gain, acquire a small 1% interest in the partnership, and not have to currently worry about taxes.
Additionally, liability relief is treated differently. Unlike a corporation where liability relief in excess of the tax basis is taxable when a partnership assumes a partner's liability, the liability relief is only taxable if the relief exceeds the partner's basis in the partnership. If the partner contributes property for a 50% stake worth $170k with a tax basis of $60k and a liability of $90k, the partner's basis would be $105k ($60k + 50% of $90k). The debt relief of $90k would not be taxable in this example because it would simply reduce the partner's basis in the partnership to $15k ($105k - $90k).
What if you need to move the property out of the partnership? I showed you how painful that can be in a corporation. In a partnership, the rules are much more advantageous.
When property is distributed to a partner, no gain or loss is recognized. The partner will instead have a basis in the distributed property equal to the lesser of (1) the partnership's basis in the distributed property or (2) the partner's outside basis in the partnership interest. Regardless of whether the distribution of property is related to the liquidation of the partnership, the above rule remains intact.
As you can see, partnerships are clearly the more flexible entity to hold rental real estate in. Corporations will punish you for poor planning. How can you be sure your plans won't change in 10, 20, or 30 years and your corporate structure will no longer make sense? Plan for the future by building in flexibility today.
Estate Planning Issues to Consider
To get a bit morbid, let's assume you are about to pass away. You've done well building a multi-million dollar portfolio but the tax advisor you hired a long time ago recommended that all of your real estate be in a corporation. Boy, are you in for a rude surprise.
Appreciated real estate in a corporation will not received a stepped-up basis at the time of death. That's because the corporation's stock receives the stepped-up basis instead. If your heirs receive your corporate shares, they will receive a stepped-up basis in the value of the corporate shares. However, the real estate within the corporation will continue to maintain the same basis. So if your heirs then decide to sell the real estate held by the corporation, the corporation will be subject to capital gain taxes.
The only saving grace here is if we're talking about an S-Corporation where the real estate is the only asset held by the S-Corporation and the S-Corporation is liquidated after the property is sold. Because S-Corporations are pass-through entities, your heirs will receive a stepped-up basis in the S-Corporation's stock. They can then sell the property held by the S-Corporation and the full capital gain will be realized. However if the S-Corporation is liquidated, the shares of the S-Corporation are disposed, and when all is said and done, your heirs won't actually have to pay capital gain tax on the real estate sold.
But if the S-Corporation is not liquidated, we'll have tax issues later on when the property is ultimately sold.
The One Exception to "Never"
I know, I know. I said never ever place real estate in a corporation. But there is just one exception that I can think of that where placing real estate into an S-Corporation may (not will, "may") make sense.
If you live in your home for the past 2 of 5 years and it qualifies as your principal residence, you can exclude up to $250k ($500k if married) of capital gain that would have otherwise been recognized upon the sale of your residence. This is called the Section 121 exclusion.
Related: All About the Section 121 Exclusion
Interestingly, you could sell your residence to an S-Corporation that you own and trigger the Section 121 exclusion all while maintaining control (not ownership, since the S-Corporation now owns the property) or your old residence. This could be advantageous if you would like to keep your residence and rent it out.
Of course, this strategy is fraught with errors. You will need to undergo careful tax and financial planning to understand the consequences of this transaction. As I illustrated in this entire article, once real estate is in a corporation, it's not coming back out easily. The transaction will need to have economic substance, so the S-Corporation will need to pay you for the purchase of the residence. Which leads to the question of: where and how does the S-Corporation get that kind of cash?
But it has been done before and will be done again. That's the only time it may make sense to use a corporation to own real estate.
So there you have it. I hope your eyes didn't glaze over because this stuff is important. If you take one thing away from this article, it's that rental real estate, or any real estate for that matter, should never be placed in an S-Corporation. Remember that, and you'll save yourself a lot of pain later on down the line!