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S corporations can serve as an advantageous entity structure for those involved in property flipping, professional practices, or construction ventures. They offer substantial asset protection and may assist in reducing the self-employment tax burden that typically accompanies an LLC. Additionally, an S corporation can help avoid the issue of double taxation often associated with C corporations.
However, when it comes to owning rental real estate, it's wise to consider alternative entity structures. Here's the rationale behind this recommendation:
Challenges in Transferring Appreciated Real Estate
Managing real estate within an S corporation is seamless during ownership. You can collect rent, cover expenses, and register the property under the corporation's name while benefiting from asset protection.
The challenges arise when you need to transfer the property out of the entity. You might wonder why such a transfer is necessary.
There are several reasons why investors choose to move properties out of an S corporation. A common scenario involves financing. Some banks extend loans to S corporations, but other lenders insist on financing or refinancing only when the property title is in the individual's name. Another situation arises when investors convert a rental property into their primary residence.
Transferring Depreciated Real Estate May Not be Advantageous
While transferring a property with decreased value allows you to avoid taxation, it may not be the most beneficial option. While most expect that recognizing a gain occurs when the fair market value exceeds the purchase price, the same logic doesn't apply when transferring property out of an S corporation. In this case, the loss effectively disappears, as the S corporation cannot acknowledge it. Therefore, while you escape taxation, you also miss out on deductions.
Even if your property's value has declined, you might still trigger a gain. The gain upon distribution is calculated as the fair market value minus your adjusted basis. Adjusted basis refers to the purchase price minus any depreciation claimed on the property.
For example, if you bought a property for $100,000 and deducted $5,000 for depreciation annually over five years, your adjusted basis would be $75,000. If the fair market value drops to $90,000, even though it's lower than the purchase price, it's higher than your adjusted basis, potentially resulting in a $15,000 taxable gain. Always consult your tax advisor before transferring properties in or out of legal entities.
Why LLCs Might Be a Preferable Choice
Utilizing LLCs for rental properties provides greater flexibility if you need to transfer rentals to a new LLC, convert one into your primary residence, or transfer it into your personal name for refinancing. For instance, if your business encompasses both property flipping and rentals, separating the two activities can be advantageous. You can house your fix-and-flip properties in an S corporation and maintain your rental properties within LLCs.
Before forming a new entity, consult your tax advisor because exceptions may apply. It's crucial to ensure that you choose the most suitable entity structure for your real estate business.