Rental Real Estate in an S Corporation: Why the Property Can Become Expensive to Remove
An S corporation can be an effective tax structure for an operating business. It is often a poor structure for appreciating rental real estate.
The problem may not become apparent when the property is purchased. Rental income is collected, expenses are deducted, depreciation is claimed, and the annual tax returns may appear routine. The difficulty often arises years later when the owners want to move the property into a separate limited liability company, divide assets among shareholders, transfer the real estate to family members, or liquidate the corporation.
By that time, the property may have appreciated substantially while depreciation deductions have reduced its tax basis. A transfer that appears to be only an internal restructuring can then trigger much of the same taxable gain that would have resulted from an actual sale.
The Central Problem
An S corporation generally cannot distribute appreciated real estate to its shareholders without recognizing gain. Federal tax law ordinarily treats the corporation as though it sold the property for its fair market value, even when no outside buyer is involved and no cash is received.
Why Rental Property Sometimes Ends Up in an S Corporation
Real estate may be placed in an S corporation because the owner already has an operating business inside the corporation and wants to keep everything in one entity. In other situations, the owner may believe that all business assets should be held by the same company or that S corporation status is necessary to avoid self employment tax.
The structure may also result from a limited liability company making an S corporation election after it already owns rental property. Although the legal entity remains a limited liability company under state law, the election generally causes it to be treated as a corporation for federal income tax purposes. The corporate distribution rules then apply to the real estate.
These arrangements can function for many years without an obvious problem. The tax cost generally becomes visible only when the owners want the real estate outside the corporation.
An S Corporation Cannot Simply Distribute Appreciated Real Estate Tax Free
Under Internal Revenue Code Section 311(b), a corporation that distributes appreciated property to a shareholder generally recognizes gain as though it sold the property to the shareholder for its fair market value.
This rule applies to a distribution that is not part of a complete liquidation. A deed transferring the property from the corporation to the shareholder can therefore produce taxable gain even though the shareholder did not pay cash and the property remained under the same practical control.
Example of the Corporate Gain
In this simplified example, the corporation recognizes $700,000 of gain even though the property was distributed rather than sold. The example assumes that the property is not subject to debt exceeding its fair market value and that no special exception applies.
Depending on the type of property and its depreciation history, the passed through gain may ultimately include Section 1231 gain, ordinary income under the depreciation recapture rules, and gain treated as unrecaptured Section 1250 gain for purposes of the individual shareholder’s capital gain tax rate.
The problem is not that an S corporation is always subject to a separate federal corporate income tax. Most S corporation income and gain passes through to the shareholders. The problem is that the distribution itself causes the corporation to recognize the appreciation that accumulated inside the property.
Debt on the Property Does Not Eliminate the Tax Problem
Rental real estate is often subject to a mortgage. The debt must be included in the analysis, but it does not make an appreciated property distribution tax free.
Section 311(b)(2) applies rules similar to Section 336(b). If the property is subject to a liability, or if the shareholder assumes a corporate liability in connection with the distribution, the value used to calculate the corporation’s gain generally cannot be less than the amount of the liability.
At the shareholder level, Section 301(b)(2) generally reduces the amount of the distribution by corporate liabilities assumed by the shareholder and liabilities to which the distributed property remains subject.
The corporate gain calculation and the shareholder distribution calculation therefore use related but different liability rules. The mortgage balance, the property’s fair market value, the corporation’s basis, and the shareholder’s stock basis must all be reviewed together.
The Gain Passes Through Even When the Owners Receive No Cash
Under Section 1366, each shareholder generally reports a pro rata share of the S corporation’s gain. The character of that gain is generally determined as though the shareholder realized it directly from the same source as the corporation.
This can create a liquidity problem. The shareholders may owe federal and state income tax because the property was transferred, but the transaction may not produce cash that can be used to pay the tax.
The issue can become more complicated when an S corporation has multiple shareholders. The gain recognized by the corporation generally passes through to all shareholders according to the S corporation allocation rules, even when the property is distributed to only one shareholder.
A distribution to only one shareholder may also require a separate analysis of the redemption rules, compensation principles, constructive distributions, corporate law, and the S corporation requirement that all outstanding shares provide identical rights to distributions and liquidation proceeds.
The Transaction Does Not Automatically Create Two Full Layers of Tax
The shareholder basis rules must be applied before determining the final tax result.
The gain passed through from the corporation generally increases the shareholder’s stock basis under Section 1367. The distribution is then tested under Section 1368.
Section 1368 requires the shareholder’s stock basis to be determined by taking the applicable income increases for the taxable year into account. This generally includes the shareholder’s share of the gain caused by the property distribution.
For an S corporation without accumulated earnings and profits from prior C corporation years, the distribution is generally excluded from the shareholder’s income to the extent of adjusted stock basis. Any distribution amount exceeding adjusted stock basis is generally treated as gain from the sale or exchange of property.
If the corporation has accumulated earnings and profits from prior C corporation years, a portion of the distribution may instead be treated as a dividend. The corporation’s accumulated adjustments account and any applicable distribution elections can affect the ordering.
Important Technical Distinction
The corporation recognizes gain, the gain passes through to the shareholders, and the passed through gain generally increases shareholder stock basis before the distribution is tested. Additional shareholder level gain is possible, but it is not automatic in every case.
The shareholder generally receives a fair market value basis in property received in a nonliquidating corporate distribution under Section 301(d). This prevents the same appreciation from being taxed again if the shareholder immediately sells the property for the same value. It does not eliminate the tax triggered when the property leaves the S corporation.
Moving the Property Into a New Limited Liability Company May Not Solve the Problem
Owners sometimes propose transferring the real estate from the S corporation into a new limited liability company. The federal income tax result depends substantially on who owns the new entity.
A Limited Liability Company Owned by the S Corporation
If the S corporation is the sole owner of the new limited liability company and the entity is disregarded for federal income tax purposes, the property generally remains owned by the S corporation for federal income tax purposes.
The transfer may change legal title and may help segregate liabilities under state law, but it does not remove the property from the S corporation tax structure.
The federal entity classification rules are addressed in Treasury Regulation Section 301.7701 2 and Treasury Regulation Section 301.7701 3.
State transfer taxes, property tax reassessment rules, lender consent requirements, title insurance, and state law liability protection may still require separate review.
A Limited Liability Company Owned by the Shareholders
If the new limited liability company will be owned directly by the shareholders, the real estate must first leave the S corporation for federal income tax purposes. A distribution, sale, redemption, or liquidation may therefore trigger recognition of the property’s built in gain.
Changing the name on the deed or transferring the property among related entities does not by itself create a tax free result.
Liquidating the S Corporation Does Not Avoid the Gain
Closing the corporation and distributing the property in complete liquidation generally does not eliminate the problem.
Under Section 336, a corporation generally recognizes gain or loss when it distributes property in complete liquidation as though it sold the property for fair market value. If the property is subject to a liability or the shareholder assumes a corporate liability, the value used by the corporation generally cannot be less than the liability.
At the shareholder level, Section 331 generally treats the liquidation proceeds as payment in exchange for the shareholder’s stock.
The shareholder’s final gain or loss depends on the value of the property and other consideration received, applicable liabilities, and the shareholder’s adjusted stock basis after taking the S corporation’s passed through income and gain into account.
This requires a coordinated calculation. The result should not be described as automatic double taxation, but liquidation does not provide a general method for distributing appreciated real estate without recognizing the corporate gain.
Former C Corporation Status Can Add Another Tax
Additional risk exists when the S corporation was previously a C corporation or acquired appreciated property from a C corporation in certain tax deferred transactions.
If appreciated real estate is sold or treated as sold during the applicable recognition period, the S corporation may owe a corporate level built in gains tax under Section 1374.
The corporate tax reduces the amount of the gain ultimately reflected in the shareholders’ pass through calculations. It can nevertheless create a genuine additional corporate level tax cost.
The corporation’s election history, asset acquisition history, valuation records, and prior tax returns should therefore be reviewed before any distribution, sale, conversion, or liquidation is completed.
The Estate Planning Basis Problem
Appreciated property held directly by an individual generally receives a basis adjustment under Section 1014 when it is acquired from a decedent.
When an S corporation owns the property, the shareholder owns corporate stock rather than the real estate itself. The inherited stock may receive a basis adjustment under Section 1014, subject to special rules for income in respect of a decedent, but the corporation’s basis in the underlying real estate generally does not change merely because the shareholder died.
This creates a difference between the outside basis in the inherited stock and the inside basis of the property owned by the corporation.
If the corporation later sells the property, it calculates gain using the corporation’s existing property basis. The gain then passes through to the heirs and generally increases their stock basis.
The heirs’ higher stock basis may eventually produce a loss when the stock is sold or the corporation is liquidated. That loss may arise at a different time and may have a different tax character from the gain recognized on the real estate.
For example, part of the property gain may be ordinary depreciation recapture or Section 1231 gain, while a later loss on the corporate stock may be a capital loss. Timing differences and capital loss limitations can prevent the two amounts from producing an equal current tax result.
A Partnership May Offer More Basis and Distribution Flexibility
A limited liability company taxed as a partnership is not free from complexity, but partnership tax rules often provide more flexibility for real estate ownership.
Under Section 731, a partnership generally does not recognize gain or loss merely because it distributes property to a partner. The distributee partner also generally does not recognize gain except to the extent money distributed exceeds the partner’s adjusted basis in the partnership interest.
That general rule has important exceptions. A reduction in a partner’s share of partnership liabilities can be treated as a distribution of money under Section 752. Marketable securities can be treated as money. Contributed property rules under Sections 704(c)(1)(B) and 737, disproportionate distribution rules under Section 751(b), disguised sale rules, and other provisions may also trigger gain.
Partnership property distributions therefore require their own detailed analysis. The important distinction is that a partnership does not have the same general fair market value gain rule that Section 311(b) imposes on an S corporation distributing appreciated property.
A partnership may also make a Section 754 election. Following a sale, exchange, or inheritance of a partnership interest, the election can produce a transferee specific adjustment to the basis of partnership property under Section 743(b).
A Section 743(b) adjustment generally applies only to the transferee partner. An S corporation has no comparable general election that adjusts its basis in real estate for a particular shareholder following the shareholder’s death or a transfer of stock.
| Issue | S Corporation | Partnership Tax Treatment |
|---|---|---|
| Distribution of appreciated real estate | The corporation generally recognizes gain as though the property were sold for fair market value | The partnership generally does not recognize gain merely from a property distribution, although several exceptions can apply |
| Basis adjustment after death or sale | No general inside basis election comparable to Section 754 | A Section 754 election may create a transferee specific Section 743(b) adjustment |
| Economic arrangements | Income and gain generally pass through pro rata based on stock ownership | Greater allocation flexibility may be available when the partnership agreement and tax allocation rules are satisfied |
These differences do not mean that partnership treatment is always preferable. Partnership tax rules can be complex, particularly when debt, unequal contributions, special allocations, contributed property, or changing ownership percentages are involved.
The ownership structure should be selected based on the property, the owners, the financing, the estate plan, and the expected exit.
Rental Income Usually Does Not Need an S Corporation to Avoid Self Employment Tax
One of the most common reasons owners consider an S corporation is the potential employment tax treatment of business profits. That rationale usually does not apply to ordinary rental income.
Section 1402(a)(1) generally excludes rentals from real estate, together with the deductions attributable to those rentals, from net earnings from self employment.
Treasury Regulation Section 1.1402(a) 4 provides additional guidance. The exclusion generally applies to ordinary rental arrangements, but it does not apply in every situation.
Exceptions and special rules can apply to rentals received by a real estate dealer, certain agricultural arrangements involving material participation, and occupancy arrangements in which services are provided primarily for the occupants rather than merely for the maintenance of the property.
The length of a rental period alone does not determine the result. Hotels, boarding houses, tourist accommodations, and some short term rental operations may produce self employment income when the nature and extent of the services cause the payments to be treated as income from services rather than rentals from real estate.
Practical Planning Point
A property owner should not place long term rental real estate in an S corporation merely to avoid self employment tax without first determining whether the rental income was already excluded under Section 1402.
Common Alternatives for Owning Rental Real Estate
Depending on the owners and their objectives, rental real estate may instead be held through:
- Direct individual ownership
- A single member limited liability company that is disregarded for federal income tax purposes
- A multi member limited liability company taxed as a partnership
- A separate real estate entity that leases the property to an operating S corporation
Separating valuable real estate from an operating business may also reduce the risk that operating liabilities affect the property. Legal liability protection depends on state law, entity maintenance, financing documents, insurance, and the specific facts.
The best structure should account for income tax, estate planning, asset protection, financing, future ownership changes, and the anticipated sale or transfer of the property.
What to Review When the Property Is Already Inside an S Corporation
A property that is already owned by an S corporation should not be transferred before the federal and state tax consequences are modeled. The analysis should include:
- The property’s current fair market value
- The original cost and adjusted tax basis
- Accumulated depreciation and potential depreciation recapture
- The amount and type of debt secured by the property
- Whether the debt exceeds the property’s fair market value or adjusted basis
- Each shareholder’s stock and debt basis
- The corporation’s accumulated adjustments account
- Any accumulated earnings and profits from C corporation years
- Whether Section 1374 may apply
- The number of shareholders and the intended recipient of the property
- Whether a nonpro rata transfer could create additional S corporation issues
- Federal, state, and local tax consequences
- Estate planning and succession objectives
- The expected timing of a sale, refinance, gift, or liquidation
In some cases, leaving the property inside the corporation may be less costly than distributing it. In other cases, the owners may decide to recognize the tax now because appreciation is expected to continue, ownership needs are changing, or estate planning concerns have become more important.
The correct decision requires comparing the immediate tax cost with the long term consequences of keeping the property in the corporation.
Final Thoughts
An S corporation can provide meaningful tax benefits for a profitable operating business. Those benefits do not automatically make it an appropriate owner of rental real estate.
The principal concern is flexibility. Once real estate has appreciated inside an S corporation, distributing the property, moving it to a shareholder owned limited liability company, or liquidating the corporation can trigger gain based on fair market value. The shareholder basis rules may prevent a full second layer of tax, but they do not make the property freely removable.
Estate planning can also become more difficult because an adjustment to the basis of inherited S corporation stock does not directly adjust the corporation’s basis in its real estate. Unlike a partnership, the corporation has no general Section 754 election that can create a transferee specific inside basis adjustment.
Entity planning should therefore begin with the anticipated exit. Before placing rental real estate in an S corporation, owners should consider how the property may eventually be sold, transferred, divided, refinanced, or inherited.
Planning for Rental Real Estate and S Corporation Ownership
I help business owners and real estate investors evaluate entity structures, property transfers, shareholder basis, depreciation consequences, and exit planning before transactions are completed.
Schedule a ConsultationThis article provides general federal income tax information. The result of a property transfer depends on the corporation’s tax history, shareholder basis, debt, depreciation, state and local law, and the structure of the transaction.
