For real estate investors, the way you structure your rental properties can significantly affect your tax liability. It seems like social media is recommending everyone to run their business as an S Corporation. While the S Corporation is a popular structure for many small businesses, real estate investors should exercise caution—especially when it comes to holding rental properties. Here’s why:
A. Loss of Step-Up in Basis on Death
Many investors are interested in creating generational wealth for their children and grandchildren. One of the biggest tax benefits of real estate is the step-up in basis at death. When you pass away, your heirs (including a surviving spouse) inherit the property at current market value—minimizing capital gains taxes if they sell later.
- Problem: S Corp shares receive a step-up in basis when inherited; the assets held by the S Corporation (including real estate) do not receive the step-up basis treatment. Heirs will pay capital gains tax calculated with the deceased shareholder’s basis upon sale.
B. Subjecting Rental Income to Payroll Taxes
Real estate rental income is generally not subject to employer and employee taxes like Social Security and Medicare. Rental income reported on Schedule E is subject to ordinary federal income tax.
- Problem: S Corporation shareholders are required to receive reasonable compensation for the work they perform in the business, which is W2 income subject to Social Security and Medicare withholdings. Additionally, S Corporations will incur the additional costs related to payroll.
C. Getting Property Out of an S Corp is a Taxable Event
If the needs and circumstances for a real estate investor change in the future, they may need to convert a rental to a personal residence or apply for a refinance in their own name.
- Problem: Transferring the property from the S Corp to the shareholder triggers a capital gain on the property’s appreciation. If there is no cash distributed with the asset, this may create an additional hardship for the shareholder to pay the capital gains tax.
Better Entity Types For Rentals
Which ownership types maintain the benefits of rental properties that many investors seek – the ability to pass more wealth to their heirs, lower tax liability, and greater flexibility? Individual taxpayers owning rental properties may choose to hold them in their own name or hold the rental in a Limited Liability Company (LLC), either option results in rental income being reported on Schedule E of their individual tax return. Properties owned by multi-member LLCs file a separate partnership tax return (Form 1065), and each partner reports their share of income or loss on Schedule E of their personal return.
In our next blog post, we’ll discuss why the S Corporation structure might be a good option for other real estate investing activities.
