Rental Property in an S Corporation: Tax Traps, Exit Costs, and Better Alternatives
An S corporation can be an effective tax structure for an operating business. It is often a less flexible structure for appreciating rental real estate.
The problem may not be obvious while the property is being held. Rental income is collected, expenses are deducted, depreciation is claimed, and the annual tax returns can appear routine. The difficulty often becomes apparent years later when the owner wants to move the property into another limited liability company, transfer it personally, divide real estate among shareholders, complete an estate plan, or liquidate the corporation.
By then, appreciation may have increased the property's fair market value while depreciation has reduced its adjusted tax basis. Federal tax law generally does not allow an S corporation to distribute appreciated real estate to its shareholders without recognizing that built in gain.
There can also be a tax problem at the beginning of the structure. Contributing highly leveraged real estate to a corporation, or making an S corporation election for an LLC that already owns the property, can create a deemed corporate contribution and potentially trigger gain when liabilities exceed tax basis.
For broader guidance on real estate ownership, depreciation, property sales, and investor tax planning, see my Real Estate Tax Planning resource page.
Key Tax Takeaways
- An S corporation generally recognizes gain when it distributes appreciated real estate to a shareholder.
- The corporation generally recognizes the gain as though the property had been sold for fair market value.
- Debt on the property does not make an appreciated property distribution tax free.
- Contributing leveraged real estate to a corporation can trigger gain under Section 357(c) when applicable liabilities exceed the aggregate adjusted basis of the property transferred.
- An LLC that already owns rental property can create deemed corporate contribution transactions when it elects corporate tax treatment.
- Merely revoking an S election normally creates C corporation status. It does not automatically return the entity to partnership or disregarded entity tax treatment.
- Changing a corporation classified LLC back to partnership or disregarded entity treatment can be treated as a taxable corporate liquidation.
- Liquidating the S corporation generally does not allow appreciated real estate to leave the corporation tax free.
- A Section 1031 exchange can defer qualifying gain while the corporation remains the owner, but it generally does not provide a tax free method for transferring replacement property to the shareholders.
- Ordinary rental real estate income generally is not subject to self employment tax, so an S corporation often is not necessary merely to avoid self employment tax on rent.
- A separate real estate entity leasing property to an operating business can create self rental rules that recharacterize net rental income as nonpassive.
- A former C corporation can face federal Section 1374 built in gains tax and additional Section 291 recapture exposure.
- California adds its own S corporation entity level tax and applies a ten year built in gains recognition period rather than the federal five year period.
- Inherited S corporation stock can receive a basis adjustment without producing a corresponding basis adjustment inside the corporation's real estate.
Is an S Corporation a Good Entity for Rental Property?
An S corporation is not prohibited from owning rental property. The issue is whether the corporate tax rules match the owner's long term objectives for appreciating real estate.
S corporations can be useful for operating businesses in which shareholder employees provide substantial services. Rental real estate often presents different tax considerations.
Real estate investors frequently value:
- Flexibility when properties are distributed or divided among owners
- The ability to restructure ownership
- Debt allocation flexibility
- Estate planning opportunities
- Potential basis adjustments after an ownership interest is inherited or sold
- The ability to separate operating businesses from valuable appreciating property
Corporate ownership can make several of these objectives more difficult.
The Problem Is Usually an Exit Problem
Rental property can remain inside an S corporation for decades without producing an obvious ownership problem.
The tax cost often becomes visible only when the owner tries to remove the appreciated property from the corporation.
Rental Income Usually Does Not Need an S Corporation to Avoid Self Employment Tax
One reason taxpayers consider S corporation status is the potential employment tax treatment of business profits. That rationale usually does not apply to ordinary rental real estate 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.
Exceptions and different rules can apply to real estate dealers, certain agricultural arrangements, and rental operations in which significant services are provided to occupants. Hotels and similar service intensive activities can therefore produce a different result.
Do Not Elect S Corporation Status Solely Because the Property Produces Rent
Before placing appreciating rental real estate into an S corporation for employment tax reasons, first determine whether the rental income would already be excluded from self employment income under Section 1402.
Can I Contribute Rental Property to an S Corporation Tax Free?
Sometimes, but not always.
Section 351 generally provides nonrecognition when one or more persons transfer property to a corporation solely in exchange for stock and the transferors control the corporation immediately after the exchange.
That general rule does not mean every contribution of rental property to a corporation is tax free.
Debt is particularly important.
Liabilities Exceeding Basis Can Trigger Tax When Property Enters the Corporation
Section 357(c) generally requires gain recognition in a qualifying Section 351 exchange when the applicable liabilities assumed by the corporation exceed the aggregate adjusted basis of the property transferred.
Example: Highly Leveraged Rental Property Contributed to a Corporation
Assume an owner transfers rental real estate to a corporation in an otherwise qualifying Section 351 transaction.
| Item | Amount |
|---|---|
| Adjusted tax basis of property transferred | $300,000 |
| Mortgage assumed or taken subject to by corporation | $500,000 |
| Excess liabilities over adjusted basis | $200,000 |
In this simplified example, Section 357(c) can cause the owner to recognize $200,000 of gain even though no property was sold to an outside buyer and the transaction otherwise qualifies under Section 351.
The character of the recognized gain depends on the property transferred and the other applicable tax rules.
Depreciated and Highly Leveraged Real Estate Requires Extra Review
Years of depreciation can reduce tax basis while refinancing can increase debt. That combination can create Section 357(c) exposure when property is later moved into a corporation.
What Happens if an LLC That Already Owns Rental Property Elects S Corporation Status?
This is an important issue because no deed transfer may occur.
An LLC is a legal entity under state law, but its federal tax classification is determined separately.
Treasury Regulation Section 301.7701-3 provides deemed transaction rules when an eligible entity changes its federal tax classification.
Single Member LLC
If an LLC that is disregarded for federal tax purposes elects to be classified as a corporation, the owner is deemed to contribute all of the LLC's assets and liabilities to the corporation in exchange for stock.
If the LLC owns rental real estate, that deemed contribution includes the real estate and its liabilities.
Section 351 and Section 357 must therefore be considered even though the legal title to the property did not change.
Multi Member LLC Taxed as a Partnership
When an LLC classified as a partnership elects corporate classification, the partnership is deemed to contribute all of its assets and liabilities to the corporation in exchange for stock. The partnership is then deemed to liquidate by distributing the corporate stock to its partners.
If the LLC owns highly depreciated and highly leveraged rental property, the deemed corporate contribution can require a Section 357(c) analysis.
An S Election Can Change the Federal Tax Owner Without Changing the Deed
The fact that an LLC continues to own the property under state law does not mean nothing happened for federal income tax purposes.
An eligible LLC electing S corporation tax treatment can become a corporation for federal tax purposes while remaining an LLC under state law.
For broader S corporation election considerations, see Should Your Business Be an S Corporation? .
Why Is Rental Property Difficult to Remove From an S Corporation?
Section 311(b) generally requires a corporation that distributes appreciated property to a shareholder in a nonliquidating distribution to recognize gain as though the property had been sold to the shareholder for its fair market value.
The rule applies even when:
- No outside purchaser exists
- No cash is received
- The same individual controls the property before and after the transfer
- The owner is merely trying to place the property into another LLC
Example: S Corporation Distributes Appreciated Rental Property
| Item | Amount |
|---|---|
| Fair market value | $1,000,000 |
| Adjusted tax basis after depreciation | $300,000 |
| Gain recognized by corporation | $700,000 |
The corporation generally recognizes $700,000 of gain even though the real estate was distributed rather than sold.
Depending on the property and depreciation history, the gain can include Section 1231 gain, Section 1245 ordinary income, Section 1250 ordinary income when applicable, and unrecaptured Section 1250 gain.
What Happens if the Rental Property Has a Mortgage?
Debt does not eliminate the corporate gain.
Section 311(b)(2) applies rules similar to Section 336(b). If distributed property is subject to a liability, or the shareholder assumes a corporate liability in connection with the distribution, the value used for the corporation's gain calculation generally cannot be less than the amount of the liability.
At the shareholder level, Section 301(b)(2) generally reduces the amount of a nonliquidating distribution by corporate liabilities assumed by the shareholder and liabilities to which the distributed property remains subject.
The corporation's gain calculation and the shareholder's distribution calculation therefore require separate but coordinated computations.
Does the Property Distribution Create Two Full Layers of Federal Tax?
Not automatically.
The S corporation recognizes the property gain, and that gain generally passes through to the shareholders under Section 1366.
The passed through income generally increases shareholder stock basis under Section 1367 before the distribution is tested under the S corporation distribution rules.
This basis increase can prevent the same economic appreciation from automatically producing another complete shareholder level gain.
Example: Gain, Mortgage, Stock Basis, and Distribution
Assume a single shareholder S corporation owns rental real estate with the following facts:
| Item | Amount |
|---|---|
| Property fair market value | $1,000,000 |
| Corporation adjusted basis | $300,000 |
| Mortgage on property | $400,000 |
| Shareholder stock basis before property gain | $100,000 |
The corporation generally recognizes $700,000 of gain under Section 311(b).
Assuming the entire gain is allocated to the sole shareholder, the gain generally increases stock basis from $100,000 to $800,000 before the distribution is tested.
The amount of the property distribution under Section 301 is generally the $1,000,000 fair market value reduced by the $400,000 liability, or $600,000.
If the S corporation has no accumulated earnings and profits from C corporation years and no other relevant adjustments apply, the $600,000 distribution can reduce the shareholder's stock basis without producing an additional shareholder gain because the adjusted stock basis is sufficient.
The shareholder generally takes a $1,000,000 fair market value basis in the property received under Section 301(d).
The Example Does Not Mean Every Distribution Has Only One Tax Consequence
Accumulated C corporation earnings and profits, multiple shareholders, insufficient stock basis, redemptions, related obligations, and other transactions can materially change the shareholder level result.
Can I Transfer S Corporation Real Estate Into My Personal LLC?
Changing the legal title does not by itself avoid the corporate distribution rules.
LLC Owned by the S Corporation
If the S corporation is the sole owner of a new LLC and that LLC is disregarded for federal income tax purposes, the property generally remains owned by the S corporation for federal tax purposes.
Moving the deed into the subsidiary LLC can change legal ownership for state law purposes while leaving the same federal tax owner.
This can be useful for some legal or operational objectives, but it does not remove the property from the S corporation tax structure.
LLC Owned Directly by the Shareholders
If the new LLC will be owned directly by the shareholders, the real estate must leave the S corporation for federal tax purposes.
A sale, distribution, redemption, liquidation, or other transfer can therefore trigger the applicable corporate gain rules.
Separate Legal Ownership From Federal Tax Ownership
Placing property in another LLC is not itself a tax strategy. The federal tax consequences depend on who owns that LLC and how the transfer is treated for federal income tax purposes.
Can I Just Revoke the S Election and Turn the LLC Back Into a Partnership?
Merely revoking the S election generally does not accomplish that result.
If an entity classified as a corporation for federal tax purposes revokes its S election, the entity generally becomes a C corporation unless another valid classification change occurs.
A separate election to change an eligible entity from corporate classification to partnership or disregarded entity status can have substantial tax consequences.
Corporation to Partnership Classification
Treasury Regulation Section 301.7701-3 provides that an association electing partnership classification is deemed to distribute all of its assets and liabilities to its shareholders in liquidation. The shareholders are then deemed to contribute those assets and liabilities to a newly formed partnership.
Corporation to Disregarded Entity Classification
If a corporation classified LLC with one owner elects disregarded entity treatment, the corporation is deemed to distribute all of its assets and liabilities to the owner in liquidation.
The deemed liquidation is subject to the relevant corporate liquidation rules.
Changing the Tax Classification Can Be the Taxable Exit
An owner cannot generally escape appreciated real estate inside a corporation merely by changing a check the box election.
The classification rules themselves treat the conversion out of corporate status as a liquidation, which can trigger Sections 336 and 331.
Does Liquidating the S Corporation Avoid the Real Estate Gain?
Generally, no.
Under Section 336, a corporation generally recognizes gain or loss when property is distributed in complete liquidation as if the property were sold to the shareholder at fair market value.
If the property is subject to a liability or the shareholder assumes a corporate liability, Section 336(b) generally prevents the value used by the corporation from being less than that liability.
At the shareholder level, Section 331 generally treats property received in complete liquidation as payment in exchange for the shareholder's stock.
The shareholder's stock basis must therefore be coordinated with the corporation's passed through gain before shareholder gain or loss on the liquidation is determined.
Property received in a taxable complete liquidation generally takes a fair market value basis in the shareholder's hands.
Dissolving the Corporation Does Not Erase Appreciation
Legal dissolution and federal income tax liquidation are separate concepts. The general corporate liquidation rules can recognize the real estate appreciation even when no outside buyer exists.
Can a Section 1031 Exchange Get Rental Property Out of an S Corporation?
A Section 1031 exchange can potentially defer qualifying gain when the S corporation itself exchanges qualifying real property for like kind real property to be held for productive use in a trade or business or for investment.
The important point is that the S corporation remains the federal tax owner of the replacement property.
Section 1031 can change which real property the corporation owns. It generally does not change who owns the property for federal tax purposes.
If the corporation subsequently distributes the appreciated replacement property to a shareholder, Section 311(b) or the liquidation rules can still apply.
A Section 1031 Exchange Is Not Generally a Corporate Extraction Strategy
An exchange can defer a qualifying sale by the corporation. It does not generally permit the shareholder to become the personal owner of the replacement real estate without analyzing the corporate distribution rules.
What Happens if Only One Shareholder Receives the Rental Property?
This situation requires additional analysis.
The corporation can recognize gain on the property even if only one shareholder receives it, while the corporation's recognized income generally passes through according to the applicable S corporation allocation rules.
The transaction can also involve:
- Redemption rules
- Constructive distribution principles
- Compensation issues
- Shareholder stock basis
- Corporate and state law rights
- The S corporation one class of stock requirement
Does an Unequal Distribution Automatically Terminate the S Election?
No.
Treasury Regulation Section 1.1361-1 generally determines whether an S corporation has more than one class of stock by examining the corporation's governing provisions and whether all outstanding shares confer identical rights to distribution and liquidation proceeds.
An actual difference in the timing or amount of distributions does not by itself necessarily create a second class of stock when the governing provisions provide identical economic rights.
The unequal distribution can still require appropriate tax treatment based on the facts and circumstances.
Binding Unequal Economic Rights Are a Different Issue
If the corporate charter, operating documents, bylaws, or binding agreements give different shareholders different rights to distributions or liquidation proceeds, the one class of stock requirement can become a serious S corporation qualification issue.
What Is the Section 1374 Built In Gains Tax?
Most S corporations do not pay regular federal corporate income tax on their operating income. Section 1374 creates an important exception for certain corporations that previously were C corporations or acquired assets from a C corporation in specified carryover basis transactions.
If appreciated assets are disposed of during the federal recognition period, the corporation can owe a corporate level tax on qualifying built in gain.
Under current federal Section 1374, the recognition period is generally the five year period beginning on the first day of the first taxable year for which the corporation is an S corporation.
The tax generally applies only to qualifying gain attributable to appreciation that already existed at the beginning of the relevant recognition period, subject to the detailed statutory limitations.
Example: Former C Corporation Owns Appreciated Real Estate
Assume a C corporation elects S corporation status when a rental building already has substantial built in appreciation.
If the corporation sells or is treated as selling the building during the federal five year recognition period, the qualifying pre election appreciation can be subject to Section 1374 corporate level tax in addition to the normal S corporation pass through treatment.
Appreciation arising after the conversion to S corporation status is not automatically Section 1374 built in gain merely because the asset is later sold during the recognition period.
Can Section 291 Also Apply to a Former C Corporation?
Yes.
Section 1363(b)(4) provides that Section 291 applies if the S corporation, or a predecessor, was a C corporation for any of the three immediately preceding taxable years.
For Section 1250 real estate, Section 291(a)(1) generally treats as ordinary income 20 percent of the excess of the amount that would have been recaptured if the property were Section 1245 property over the amount otherwise treated as ordinary income under Section 1250.
This rule is separate from the Section 1374 built in gains tax.
Former C Corporation Status Requires More Than One Review
A recently converted S corporation selling depreciated real estate can require separate analysis of Section 1374, Section 291, Section 1250, Section 1231, and the shareholder pass through consequences.
For more information about the depreciation rules, see Depreciation Recapture on Rental Property .
California Can Add an Entity Level Tax Cost
California does not treat an S corporation exactly like the federal government.
California generally imposes a 1.5 percent franchise or income tax on an S corporation's California net income, subject to the applicable minimum franchise tax rules.
A distribution or sale of appreciated California real estate that creates income at the S corporation level can therefore create California entity level tax in addition to the shareholder's California tax consequences.
California Built In Gains Period Is Longer Than the Federal Period
California Revenue and Taxation Code Section 23809 modifies the federal built in gains rules by substituting a ten year recognition period for the federal five year period.
California generally applies an 8.84 percent rate to qualifying California source built in gains under its Section 1374 conformity rules, with the Form 100S computation coordinating that tax with the regular S corporation tax.
Federal Built In Gains Exposure Can End Before California Exposure
A former C corporation can be outside the federal five year Section 1374 recognition period while still remaining inside California's ten year recognition period.
A California real estate transaction should therefore not rely solely on the federal Section 1374 timeline.
California property transfers can also have property tax, documentary transfer tax, title, lender, and other state or local consequences that are separate from the federal and California income tax calculations.
What Is the Estate Planning Problem With Real Estate in an S Corporation?
Section 1014 generally adjusts the basis of qualifying property acquired from a decedent to its applicable estate tax value.
When an individual owns real estate directly, the real estate itself can receive that basis adjustment when the statutory requirements are satisfied.
When an S corporation owns the property, the shareholder owns stock. The shareholder does not personally own the corporation's rental building.
The inherited S corporation stock can generally receive a Section 1014 basis adjustment, but the corporation's tax basis in the underlying real estate does not generally increase merely because a shareholder died.
Example: Stock Basis Increases but Building Basis Does Not
Assume a shareholder dies owning S corporation stock worth $1,500,000.
The corporation owns rental property worth $1,500,000 with an adjusted tax basis of $400,000. Assume there are no other material assets or liabilities for purposes of this simplified example.
The heir can receive a basis in the inherited stock based on the applicable Section 1014 value.
The corporation's basis in the rental property generally remains $400,000.
If the S corporation later sells the property for $1,500,000, the corporation still measures its property gain using its inside basis rather than the heir's basis in the stock.
The property gain can pass through to the heir and increase stock basis. A later sale or liquidation of the stock can potentially produce a loss, but the timing and character of that stock loss can differ from the gain recognized on the real estate.
This mismatch is one reason estate planning can be less flexible when appreciating real estate is held inside an S corporation.
Would a Partnership Provide More Estate Planning Flexibility?
A partnership can potentially make a Section 754 election that produces a transferee specific adjustment under Section 743(b) following certain sales or exchanges of partnership interests or the death of a partner.
That adjustment can create an inside basis adjustment for the transferee partner without changing the common inside basis applicable to the other partners.
An S corporation does not have a comparable general election that adjusts the basis of its real estate for one shareholder merely because that shareholder's stock was inherited or sold.
Is a Separate Real Estate LLC Usually Better?
A common structure is to keep valuable real estate outside the operating S corporation.
Depending on the owners and the facts, the real estate might instead be held through:
- Direct individual ownership
- A single member LLC disregarded for federal tax purposes
- A multi member LLC taxed as a partnership
- A separate partnership
- Another appropriate real estate ownership vehicle
The separate real estate entity can then lease the property to the operating S corporation.
This keeps the appreciating real estate outside the operating corporation while allowing the business to use the property.
What Is the Self Rental Rule?
Separating the building from the operating S corporation creates another passive activity issue that should not be overlooked.
Treasury Regulation Section 1.469-2(f)(6) generally treats net rental activity income from property rented to a trade or business in which the taxpayer materially participates as nonpassive income.
This is commonly called the self rental rule.
Example: Real Estate LLC Leases Building to Owner's S Corporation
Assume an individual owns an operating S corporation and materially participates in that business.
The same individual owns the business building through a separate LLC and leases it to the S corporation.
If the rental activity generates net income, the self rental rule can treat that income as nonpassive.
The owner therefore should not assume that profitable rent from the building can be used to absorb unrelated passive activity losses.
The Self Rental Rule Is Asymmetrical
The regulation specifically recharacterizes applicable net rental income as nonpassive. A rental loss does not automatically become nonpassive merely because profitable years would be subject to the self rental rule.
For more information about passive activity losses, see Suspended Passive Rental Losses: Four Ways Real Estate Investors Can Use Them .
How Does an S Corporation Compare With Partnership Tax Treatment for Real Estate?
Partnership tax rules can be complicated, but they generally provide greater flexibility for appreciating real estate.
| Issue | S Corporation | Partnership Tax Treatment |
|---|---|---|
| Contributing property | Section 351 can provide nonrecognition, but Section 357(c) can trigger gain when applicable liabilities exceed basis | Section 721 generally provides nonrecognition, subject to liability, disguised sale, and other rules |
| Distribution of appreciated property | Corporation generally recognizes gain at fair market value | Partnership generally does not recognize gain merely from distributing property, subject to important exceptions |
| Owner receiving property | Shareholder distribution or liquidation rules apply | Sections 731, 732, 751, 752, 704(c), 737, and other partnership rules can apply |
| Basis adjustment after death or sale | No general shareholder specific inside basis election | Section 754 election can create a Section 743(b) transferee specific adjustment when applicable |
| Allocation flexibility | Income, gain, loss, and deduction generally allocated based on stock ownership under S corporation rules | Greater economic allocation flexibility can be available subject to Section 704 and the partnership agreement |
| Removing appreciated real estate | Often triggers corporate gain | Can be more flexible but is not automatically tax free |
Partnership treatment is not automatically superior. Debt shifts, disguised sales, contributed property, disproportionate distributions, hot assets, special allocations, and changes in ownership can all create complex tax consequences.
The important distinction is that a partnership does not have the same broad fair market value gain rule that Section 311(b) imposes when a corporation distributes appreciated property.
What if I Sell the S Corporation Stock Instead of the Real Estate?
A stock sale is fundamentally different from the corporation selling or distributing the real estate.
If a shareholder sells S corporation stock, the corporation generally continues to own the rental property. The shareholder instead recognizes gain or loss on the stock disposition under the applicable stock sale rules.
The buyer generally acquires stock in a corporation that still owns the property with its existing inside tax basis.
That inside basis can make a stock purchase less attractive to a buyer who wants a new tax basis in the real estate.
In qualifying transactions, elections under Section 338(h)(10) or Section 336(e) can cause a stock transaction to be treated substantially as a deemed asset sale for federal income tax purposes. Those elections have detailed eligibility and consent requirements and can recreate many of the tax consequences associated with selling the underlying assets.
Stock Sale and Asset Sale Economics Can Be Very Different
A seller may prefer stock sale treatment while a buyer may prefer asset basis. The tax structure can therefore become part of the purchase price negotiation.
What Should Be Reviewed When Rental Property Is Already Inside an S Corporation?
Before transferring, selling, exchanging, or liquidating property already owned by an S corporation, the analysis should generally include:
- Current fair market value of the real estate
- Corporation adjusted tax basis
- Land and building allocation
- Accumulated depreciation
- Cost segregation components
- Section 1245 and Section 1250 classification
- Mortgage and other property liabilities
- Each shareholder's adjusted stock basis
- Accumulated adjustments account
- Accumulated earnings and profits from any C corporation years
- Number of shareholders and ownership percentages
- Whether the property will be distributed to all shareholders or only one
- Corporate governing documents and distribution rights
- Prior C corporation history
- Federal Section 1374 recognition period
- Potential Section 291 exposure
- California built in gains recognition period
- California S corporation entity level tax
- Potential Section 1031 exchange alternatives
- Estate planning objectives
- Whether the property might instead remain inside a corporation owned subsidiary LLC
- Whether a stock sale is a practical alternative
Model the Tax Before Recording a New Deed
Once appreciated property is transferred from the corporation to its shareholders, the taxable event may already have occurred.
The federal and state consequences should therefore be modeled before documents are signed or recorded.
Planning Before Rental Property Enters an S Corporation
The most valuable planning often occurs before the structure is created.
Before contributing rental property to a corporation or electing S corporation treatment for an LLC that already owns real estate, review:
- Property fair market value
- Adjusted tax basis
- Current mortgage and other liabilities
- Potential Section 357(c) gain
- Expected future appreciation
- Expected ownership changes
- Estate planning objectives
- Whether the real estate should remain separate from an operating business
- Whether partnership or disregarded entity treatment provides greater flexibility
- Whether ordinary rental income is already excluded from self employment tax
A structure that appears administratively convenient today can become expensive to unwind after years of appreciation and depreciation.
Frequently Asked Questions About Rental Property in an S Corporation
Is an S corporation a good entity for rental property?
An S corporation can legally own rental property, but appreciating real estate can be difficult to remove because corporate distributions of appreciated property generally trigger gain. The appropriate structure depends on the owners, debt, expected appreciation, estate plan, and future exit strategy.
Why is rental property in an S corporation difficult to remove?
Section 311(b) generally requires the corporation to recognize gain as though appreciated property distributed to a shareholder had been sold for fair market value. The rule can apply even when no cash changes hands.
Can an S corporation distribute rental property to a shareholder tax free?
Generally not when the property's fair market value exceeds the corporation's adjusted basis. The corporation ordinarily recognizes the built in gain under Section 311(b). The shareholder distribution consequences must then be calculated separately.
What happens if the S corporation rental property has a mortgage?
Debt does not eliminate the gain. For the corporation's gain calculation, the property's value generally cannot be treated as less than the applicable liability. The liability also affects the shareholder's distribution calculation under separate rules.
Can I transfer S corporation real estate into my personal LLC?
If the new LLC is owned directly by the shareholder, the property must leave the S corporation for federal tax purposes. A distribution or other transfer can therefore trigger corporate gain. An LLC owned entirely by the S corporation generally does not remove the property from the S corporation for federal tax purposes.
Can an LLC that owns rental property elect S corporation status?
An eligible LLC can elect S corporation tax treatment, but the election can create deemed corporate contribution transactions under the federal entity classification regulations. Property basis, liabilities, and Section 357(c) should be reviewed before the election becomes effective.
Can liabilities exceeding basis trigger tax when property enters an S corporation?
Yes. In an otherwise qualifying Section 351 transaction, Section 357(c) can recognize gain when applicable liabilities assumed by the corporation exceed the aggregate adjusted basis of the property transferred.
Can I revoke the S election and convert the entity back to an LLC?
Revoking the S election generally causes the entity to become a C corporation for federal tax purposes. It does not by itself restore partnership or disregarded entity treatment. A separate classification change can be treated as a corporate liquidation and can trigger tax on appreciated real estate.
Does converting an S corporation LLC to a partnership trigger tax?
It can. Treasury Regulation Section 301.7701-3 generally treats an association changing to partnership classification as first distributing all assets and liabilities to its shareholders in liquidation. The shareholders are then treated as contributing those assets and liabilities to a new partnership.
Does liquidation of an S corporation avoid the real estate gain?
Generally, no. Section 336 generally treats the corporation as selling distributed property for fair market value in a complete liquidation. Section 331 separately determines the shareholder's gain or loss on the liquidation.
Can a Section 1031 exchange get rental property out of an S corporation?
Generally, no. A qualifying Section 1031 exchange can allow the S corporation to exchange qualifying real property for replacement real property while deferring applicable gain. The replacement property remains owned by the S corporation for federal tax purposes. A later distribution to the shareholder can still trigger the corporate distribution rules.
Does rental income need an S corporation to avoid self employment tax?
Usually not for ordinary rental real estate. Section 1402(a)(1) generally excludes rentals from real estate from net earnings from self employment. Exceptions can apply to dealers, certain agricultural arrangements, and rental operations involving significant services.
What is the self rental rule?
When property is rented to a trade or business in which the taxpayer materially participates, Treasury Regulation Section 1.469-2(f)(6) generally recharacterizes applicable net rental income as nonpassive. The rule does not similarly convert an applicable net rental loss into nonpassive loss merely because the related business is nonpassive.
Does inherited S corporation stock receive a basis adjustment?
Qualifying stock acquired from a decedent can generally receive a basis adjustment under Section 1014. The corporation's basis in the underlying real estate generally does not change merely because a shareholder dies.
Does the rental property itself receive a basis adjustment when an S corporation shareholder dies?
Generally, no. The decedent owned S corporation stock rather than the corporation's real estate. The inherited stock can receive a basis adjustment while the corporation generally retains its existing inside basis in the property.
What is the Section 1374 built in gains tax?
Section 1374 can impose federal corporate level tax on qualifying built in gain when a former C corporation or certain S corporations holding carryover basis C corporation assets recognize that gain during the applicable recognition period. The current federal recognition period is generally five years.
Can Section 291 apply to an S corporation that recently was a C corporation?
Yes. Section 1363(b)(4) provides that Section 291 applies when the S corporation or a predecessor was a C corporation during any of the three immediately preceding taxable years. For Section 1250 property, this can create additional ordinary income treatment.
How does California tax an S corporation that owns appreciated real estate?
California generally imposes a 1.5 percent S corporation tax on California net income, subject to applicable minimum franchise tax rules. California also has a built in gains tax regime for qualifying former C corporations. California Revenue and Taxation Code Section 23809 uses a ten year recognition period rather than the current federal five year period.
Is a partnership usually better for owning appreciating real estate?
Partnership tax rules generally offer greater distribution, allocation, and basis adjustment flexibility for real estate, but partnership ownership is not automatically tax free or simpler. Debt, contributed property, disguised sale, special allocation, and distribution rules must still be considered.
What happens if only one S corporation shareholder receives the property?
The corporation can still recognize gain, while the gain generally passes through under the S corporation allocation rules. The transaction can also involve redemption, compensation, constructive distribution, stock basis, and corporate law issues. An actual unequal distribution does not by itself automatically create a second class of stock, but binding unequal distribution or liquidation rights can threaten S corporation qualification.
Can I sell the S corporation stock instead of selling the rental property?
Yes, if a buyer is willing to purchase the stock. A stock sale generally leaves the real estate inside the corporation with its existing inside basis. Depending on the transaction, special elections such as Section 338(h)(10) or Section 336(e) can potentially produce deemed asset sale treatment when all requirements are satisfied.
Final Takeaway
The primary tax problem with rental property in an S corporation is not that the corporation cannot own real estate. It is that appreciating real estate can become expensive and inflexible to remove.
That problem can arise at both ends of the ownership cycle.
When leveraged property enters corporate tax treatment, Section 357(c) can trigger gain if applicable liabilities exceed tax basis. When appreciated property later leaves the corporation, Section 311 or Section 336 can require gain recognition based on fair market value.
A later entity classification change, liquidation, or Section 1031 exchange generally does not provide a simple way around those corporate ownership rules.
Former C corporation status, California taxation, estate planning, depreciation, debt, and multiple shareholders can add additional layers of complexity.
For these reasons, the ownership structure should ideally be evaluated before appreciating real estate enters an S corporation. If the property is already inside the corporation, the tax consequences should be modeled before any transfer, liquidation, classification change, or deed is completed.
Review the Entity and Exit Structure Before Moving Rental Property
I assist real estate investors and business owners with rental property entity and exit structure reviews. The analysis can include property basis, fair market value, mortgages, depreciation, cost segregation, shareholder stock basis, Section 311 distributions, Section 357 contributions, LLC classification changes, liquidation, Section 1031 alternatives, former C corporation history, Section 1374, Section 291, California tax, and estate planning considerations.
The objective is to determine the expected federal and state tax consequences before the property is transferred and identify alternatives while the ownership structure can still be planned.
Schedule a ConsultationThis article provides general federal and California income tax information. The tax treatment of rental property held by an S corporation depends on the property's adjusted basis, fair market value, liabilities, depreciation history, ownership structure, shareholder basis, corporate history, governing documents, transaction structure, and other facts. State and local property tax, transfer tax, legal, financing, and title consequences can require separate analysis.
