Bob Weaver-The Real Estate and Business Tax Guru

One of my Real Estate Commandments is “Thou Shalt Not Put Real Estate in a Corporation.” Here are my top ten reasons why not.  And if you are thinking “Hey what about C corporations” just know that most of the items below also apply to C corporations and there are ramifications for C corporations that are even worse than what is listed below.  You are just going to have to trust me on that.  It also should be noted that this list is targeted for real estate operators and investors.  If you are building homes and selling them as a business, many of these concerns do not apply. 

So here are my reasons, in no particular order:

1. Allocation of income and losses and distributions of cash and property must be made in accordance with the number of shares owned.  No special deals are allowed. Any variations from this have to be handled in the form of payroll.
2. Shareholders in S corporations are often limited in their ability to deduct rental losses.  All tax losses are limited to the shareholder’s basis in the S Corporation stock, which does NOT include third party debt, such as a mortgage. This is true even if the debt is guaranteed by the shareholder. This can result in higher taxes.
3. Borrowing money in the corporation and distributing it to a shareholder is often taxable because of the basis limitations discussed above.  This makes it difficult to cash in on the equity in the property.
4. Most residential lenders will NOT give a mortgage to an S corporation.  While this can be true of LLCs as well, the workarounds for LLCs are NOT available to S corporations
5. Distributions of appreciated real estate to the owners from the S Corporation are taxable.  This is true of any distribution and especially important if the owners want to split up.  Liquidating the entire S Corporation that has appreciated assets is a taxable event and so is redeeming a shareholder’s stock with appreciated assets.  This is extra tough on the owners if there is no distribution of cash to pay the tax.
6. Transfers of debt-free appreciated property to an S Corporation are taxable if the contributing shareholder is not in control of the corporation immediately after the transfer. This makes it difficult to set up ownership between a “money” partner and “sweat equity” partner.
7. Transfers of mortgaged property to an S Corporation does not increase the basis of your S Corporation stock and thereby could severely limit the deductibility of future losses from that property.
8. S Corporations cannot have any of the following as shareholders: corporations, partnerships and non-resident aliens. Certain trusts, many LLCs and most S corporations are also prohibited from owning an S corporation.
9. There is no step-up in basis for the assets within the S-Corporation when a shareholder dies or someone buys stock. (The S Corporation stock gets a step-up, but not the inside assets).
10. S Corporations historically have had a much higher audit risk than LLCs.

This is not to say LLCs are perfect, but if you are looking to protect yourself from the perils of real estate ownership by forming an entity, whatever you do, don’t put it in a corporation!

I talk to a lot of folks that have lost a rental to a foreclosure. They bought it at the peak, they have had trouble keeping it rented, they can no longer afford the negative cash flow, etc. So the bank takes it, hopefully the bank does not pursue them for the deficiency, and life goes on. We all make bad investments from time to time.

But these same folks freak out when thy receive a 1099 from from the bank that held the mortgage for the unpaid deficiency. They check with their friends etc. and oh my gosh it’s INCOME! And the anxiety they felt when they lost the property all comes rushing back. Not to worry. Bob and his magic wand is here. Bob will waive it and poof, the income disappears.

Forgive me for being flippant, but unless the rental goes back to the days where the taxpayer was able to refinance and take out equity, the taxpayer probably has enough cost basis in the property to create a big loss that offsets most if not all of debt relief income especially if they put in a fair amount of cash into the deal.

Example. James buys a rental house for $100,000 putting $20,000 down and an interest only mortgage of $80,000. James’ tax basis is $100,000. He owns it for 3 years. During that time he depreciates the property (a paper-only tax write-off) $9,000. James loses the house at a time when the house is valued at $60,000. Since the bank was owed $80,000, they send a 1099 for $20,000. Yes indeed, that is $20,000 of income.

But James also has a tax loss. His tax basis is $91,000, the original $100,000 less the $9,000 in depreciation he took. In a foreclosure like this, James is deemed to have sold the property for its $60,000 value, for a loss of $31,000 ($60,000 – $91,000). Because it is a rental, and the rental is now totally gone, James can write off the whole $31,000 against the $20,000 debt relief income and any other income he has. If James had a suspended loss he could not deduct in prior years (that happens to higher income taxpayers) he can write that off too.  James’ net loss is $11,000, which makes sense if you think about it. He put in $20,000 and got $9,000 in tax write-offs.

This works for single family rentals, apartment buildings, shopping centers, etc. but not your residence. Residences come under completely different rules. So if you get one of these 1099s and you want to freak out, think about the possible loss you have, or contact me, and I will get out my magic wand.