The Hidden Tax Trap of Owning Real Estate in an S-Corp
Choosing an entity structure is not just a legal decision, it is a critical tax planning strategy with long-term consequences. The type of entity that owns real estate will have long term tax consequences. All types of ownership have pros and cons. These should be analyzed for your specific situation and ownership should be tailored accordingly. For real estate owners, overlooking these issues can result in substantial, and sometimes avoidable, tax liabilities.
One common but costly mistake is owning real estate inside a Corporation, an S-Corporation or a C-Corporation. Although it may seem like a straightforward setup, it can lead to unintended tax burdens, especially during a sale or after the death of a shareholder.
The Step-Up in Basis Problem
When real estate is owned individually or through a pass-through entity like an LLC taxed as a partnership, the heirs of a deceased owner generally receive a step-up in basis. This means the property’s tax basis is adjusted to its fair market value as of the date of death. The step-up can significantly reduce or eliminate capital gains tax if the property is sold after the owner passes away.
S-Corporations are treated differently. If a shareholder passes away, the tax basis of their stock is stepped up to fair market value for that shareholder, but the S-Corporation’s basis in the property itself does not change. The property retains its original basis inside the corporation, regardless of changes in corporate ownership caused by death.
When the S-Corporation sells the property, it must report the gain based on the property’s original purchase price, not its current market value. This often results in a significant capital gains tax bill for all shareholders, including the surviving owners.
Why This Matters
This issue typically comes to light at major financial events such as the sale of the property, the death of an owner, or business succession planning. By the time these events occur, it is usually too late to change the outcome. Distribution of property from an S-Corporation is equivalent to a sale of the underlying property. Therefore, any gain is taxable to the owners. Once real estate is inside a corporation, getting it out in a tax-efficient way is extremely difficult, if not impossible.
Best Practices for Real Estate Owners
- Avoid placing real estate inside any type of corporation whenever possible.
- Consider using an LLC taxed as a partnership, which allows for a step-up in basis upon the death of an owner and greater tax flexibility.
- Review your entity structure with a qualified tax advisor before any major transactions, ownership changes, or succession events.
- If property is already owned inside a corporation, understand the limitations and consult a tax professional about whether any restructuring options are available. Options are often limited but understanding the risks is essential.
Plan Ahead to Protect Your Wealth
An LLC, holding real estate, can be easily converted to an S-Corporation or a C-Corporation, however the reverse is not true. Once assets are placed in a corporation it can be very tax inefficient to distribute these assets to owners.
If you are unsure whether your current ownership structure is protecting your interests, your ShindelRock team can help you evaluate your options and plan proactively to avoid costly tax surprises.