Despite efforts in recent years to simplify it, the U.S. Internal Revenue Code (IRC) remains extraordinarily complex. There exist many distinctions that are hidden from plain view. Particularly when it comes to real estate, falling on the wrong side of one such distinction can be very costly.
For owners of rental properties, S Corporations have a range of potential upsides — most notably, that they may help reduce a portion of the self-employment taxes since S Corp owners can classify money as partly income and part distribution. But when it comes time to sell, S Corp owners can find themselves between a rock and a hard place.
Placing it under an S Corp.
Let’s say that, five years ago, you purchased a rental property for $100,000, and put it in the name of an S Corp. In the intervening half-decade, the property’s fair market value rose to $400,000. Naturally, you decide that now is a good time to sell.
Also, naturally, you’d like to avoid paying capital gains taxes on the $300,000 of profit you’ll be making when you do sell. After some research, you find that you can exclude this gain from your taxable income if you make the property your primary residence. This requires you to live in the property for two of the five years prior to the sale. “Okay,” you say, planning to make the property your primary residence, and deciding to sell in 24 months.
However, by making the property your primary residence, you’d be taking it out of the name of the S Corp. This would trigger IRS alarm bells. The IRS would treat this move not merely as a name transfer, but as a sale, even though no money exchanged hands. That means that you’d essentially be selling yourself the property for $400,000, and making $300,000 of taxable capital gains.
To be clear: You wouldn’t be making any money, but you’d be taxed as if you were making an additional $300,000. Depending on how much cash you had on hand, that could be a huge problem.
Also, if you were one of several owners of the S Corp, all of you would be liable for paying your share of the gains tax. If you owned the S Corp with two business partners, each of you would be liable for capital gains tax on $100,000. Potentially disastrous.
But if, in the first place, you’d put the property in the name of an LLC, you’d be facing a much rosier picture.
If you had made a property once held as an LLC into your primary residence, the IRS would treat it not as a transaction, but as a distribution. This means there would be no $300,000 gain to tax when the property was transferred, and that, when you eventually sold, you’d have a chance of excluding the $300,000 gain from your taxes.
In this scenario, holding the rental property in an LLC would have made more sense. Likewise, if you need to move rentals to a new LLC or transfer a property to your personal name to refinance, having used an LLC, to begin with, would provide you with the most flexibility. LLCs are not always the answer though — there are reasons some investors think fix and flip properties function best in S Corps. If your business involves both rentals and fix and flips, it might make sense to set up an LLC for the former, and an S Corp for the latter.
But as always, to put yourself in the most favorable circumstances come tax season, it’s best to consult with a tax advisor. They will be able to outline scenarios like these, fitted to the specifics of your projects and properties. In our scenario above, the distinction between S Corp and LLC was very fine indeed. Don’t tempt fate; trust the tax experts.