Bob’s Top 10 Reasons to NOT Own Real Estate in an S Corporation
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:
- 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.
- 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.
- 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.
- 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
- 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.
- 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.
- 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.
- 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.
- 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).
- 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!
Bob Weaver-The Real Estate and Business Tax Guru 
nice article, you answered my question in regards to an s corp shareholder who bought a rental under his name not the corporations and donated i.t to the s corp. even though it is a recourse mortgage (varies per state) AND he is directly responsible for it, it does not meet the definatoion of the economic outlay docrtine, and therefore, not an increase in debt basis. Of course he gets an increase in his outside basis by the amount of adjust basisi in the property contributed. If i am incorrect, please let me know at cfpdiamond@aol.com
Joe Diamond
July 31, 2011 at 6:49 am
The issue of contributing a loan to the corporation complicates the issue further. What you describe is often done without transferring the property legally, the loan most likely remains in the transferor’s name and not the corporation’s and furthermore such a transaction typically violates bank covenants. What you have here is a mess. Without seeing the underlying paperwork and knowing the laws of your state, its hard to tell what the IRS would do with this.
rpwcpa
August 1, 2011 at 11:00 am
you are absolutly correct, but yes the title was transferred to the s corp. the issue was that the s corp did not purchase the property nor get the loan in its name, and i understand that even though if it did, and the shareholder guaranteed the loan, still no increase in basis. BUT if the shareholder originally got the mortgage in his name and then contributed the mortgage property to the s corp. isn’t that the same as getting a loan from the bank in your name and then lending it to the s corp? which IS then an increase in the shgareholders outside basis.
Joe Diamond
August 6, 2011 at 10:03 am
For a loan to be used for basis, the shareholder must be the creditor. It appears the taxpayer has assigned the obligation to pay the loan to the corporation. That is not the same thing. Even if the taxayer is still primary obligor, i do not think that creates basis in the S corporation.
rpwcpa
August 7, 2011 at 8:22 pm
your point is well taken, BUT, i would only agree with you that when a shareholder personally guarantees an “obligation of the corporation” it is not increase in basis, unless, and only unless an actual economic outlay occurs by having the shareholder actually pay the debt if the corporation defaulted on it. If you personally take a loan from a bank and then loan it to the corporation, this is not an obligation of the corporation, this will increase basis even though the corporation is making payments on it because the shareholder is the only party responsible and the bank can only go after the shareholder, not the corporation. the same would exist if the shareholder directly loaned money to the corporation and the corporation made payments back to the shareholder, your debt basis would increase then decrease as payments are made back to shareholder.
As far as the mortgage is concerned ive been treating the contribution of the property to the corp in the same manner as you would in a partnership……your baisis is first increased by the adjusted basis of the property, then it is decreased by the mortgage assumed by the partnership/corporation, then it is increased by the mortgage amount re-assumed by the partner/shareholder IF you are personally responsible (assuming you are in a recourse state) even though the partnership/coproration is making the payments, so this transaction happens all at once. the fact that there is a mortgage attached to the property has a no net affect on the basis since the shareholder is still responsible. On a partnership K-1, for all practical purposes you can derrive the partners basis by adding the “capital account” balance to the “recourse/non-recourse/qualified non-recourse” balance. For the s corp the K-1 does not reflect this information.
please reply, i am enjoying this discussion very much. My reply could be innacurate but this is what I have learned, I need a practicing cpa like yourself to keep me in line and on track, your friend, joe
Joe Diamond
August 8, 2011 at 5:58 am
You make a mistake in comparing a partnership to an S corporation. You initially describe what is commonly known as a negative capital account in a partnership. The allocation of recourse debt to the owner as basis does not apply to S corporation shareholders.
I think what you are asserting is that you have effectively contributed the property and not the debt. In all my experience I have not seen such an animal. That doesn’t mean it cannot be done, but I remain skeptical. As far as the bank is concerned, who is the primary obligor on the loan? Is it really the shareholder? And if is, what is the bank’s recourse against the property itself? Are you saying it’s the shareholder’s loan and the corporation is helping out the shareholder by allowing its property to secure the shareholder’s loan? And does the bank even know that ownership has been transferred to the corporation? If not, has this transaction violated any loan covenants? I think you describe a legal quagmire here unless the corporation has become the primary owner with the bank’s OK, and if that hapens, you lose your basis argument.
rpwcpa
August 8, 2011 at 11:46 am
I agree with and understand your first paragraph. the shareholder is the only obligor on the loan, it is also a recourse state. the bank’s only recourse is the shareholder, not the corporation, it can foreclose on the property and then issue a deficiency judgement against the shareholder. the title was transferred from the shareholder to the corporation, but the note/mortgage is not in the name of the corporation. the bank does not know the title was transferred. yes the transfer does violate the terms and conditions of the mortgage by not getting permission from the bank to transfer title.
this is how theshareholder presented his corporation to me a couple years ago. I told him that what was done was done incorrectly, but as you may know, so many people deal with property in this manner.
Joe Diamond
August 9, 2011 at 4:50 am
I think that with the corporation making the payments and owning the property, the corporation has de facto assumed the loan, and your basis would be the cost of the property, net of the mortgage. What you might want to look into is what is called a wraparound mortgage. I googled the term and came up with some good discussions of it. In your case the shareholder would make loan to the corporation on a second mortgage that is written to be “all inclusive” of the first mortgage. The bottom line is that the corporation pays the sharholder $X, and then the shareholder pays bank $X. IRS is still not going to like it, but your argument has legs.
rpwcpa
August 10, 2011 at 9:28 am
Great tips and info on why buying real estate under a corporation name is a bad idea and should be avoided.
june
November 8, 2012 at 8:41 am
Does all of the same apply if you have an LLC registered with your state, but file a 2553 with the IRS in order to save on taxes?
DaCapitan
June 27, 2014 at 10:23 am
Yes the same rules apply to LLCs that elect to be taxed as S corporations. From a tax standpoint the LLC that elects to be taxed as an S corporation is identical to a standard S corporation. And I had to cringe at your phrase “but file a 2553 with the IRS in order to save
on taxes.” If you are investing in real estate, filing Form 2553 is going to do just the opposite.
Bob
rpwcpa
June 27, 2014 at 11:11 am
We’re facing perhaps an unusual situation. I live in Illinois and have the opportunity to purchase my old elementary school in Michigan. We could acquire the property — school building and 4 acres of land — for $1. The building is in great shape, and the property has been appraised (with some difficulty, as there are no comps) for $80,000. The building has been well kept in the 10 years it’s been vacant, and will cost about $15,000 a year for me to maintain in its current condition until we decide what to do with it. We would like to eventually turn the school into a community center but, until that can happen, the school will probably remain vacant for at least another year or two. We don’t yet know what property tax will be (though taxes in the area are very low), and insurance for the property will probably be an additional $1600 to $2000 per year. Any improvements to the building (while not pressing, it could use a new roof, which would run around $20,000) will be in addition to the $15,000 annual maintenance. Our tax accountant suggested that I form an S corporation (though she was vague on whether I should do this in my home state of Illinois or in Michigan, where the property is located) to which I would personally loan money in order to fund the ongoing requirements of the property, which would make the expenses tax deductible. Is this not a good idea in our circumstances? I need to make a decision soon, and I’m really not sure if or how I should proceed. Any suggestions?
Patricia Butler
October 30, 2014 at 12:04 pm