What kind of real estate should be held in a legal entity?
Investment property should be kept separate from your personal assets. If you invest in property for purposes of renting and/or flipping for profit, holding said property in your own name increases your legal and financial risks. Whereas, owning the property in an entity– in contrast, decreases your legal liability if an incident occurs on the property and someone decides to file suit for any damages they’ve incurred because of said incident.
What kinds of legal entities can hold real property?
A person who is the sole owner of a property can create a single-member limited liability company or “LLC” to have own the property, these LLC’s are defaulted as “pass-through” entities, meaning that all profits of the entity pass-through to the individual owner’s income tax return, so no separate tax filing is required on behalf of the LLC.
A property that is held by an LLC with multiple owners, is considered a multi-member LLC or partnership. Of course, you can also have the option of owning property through a corporation as well. These structures protect the owners’ personal interests and assets from liability. Each entity has its own unique legal, tax, and operational implications. For example, one of the drawbacks of holding real property in a corporation is that the companies’ revenue is subject to double taxation, once at the business level and then again when the owners file their personal tax returns in the event they choose to take distributions quarterly or at the end of the year.
Why shouldn’t real estate be held in an S-Corp?
There are two types of corporations recognized by the IRS, those are (i) s-corporations, and (ii) c-corporations. S-corporations– unlike c-corps are most appealing because they enjoy the same favorable aspects of a single-member LLC– in that it has the pass-through taxation aspect. However, s-corps have certain requirements that must be adhered to in order for the company to be qualified by the IRS. Moreover, s-corporations also have various tax implications, as many actions trigger a taxable event. The contribution of appreciated property to an s-corporation is subject to tax if the contributing shareholder owns less than 80% of the majority vote after the transfer. When s-corporations distribute profits to shareholders and when shareholders liquidate their stock, they are subject to tax. Contributions to LLC’s and distributions of appreciated LLC property to members are tax-free. Not all shareholders will qualify to deduct s-corp losses from other income sources. Losses from passive income in an s-corp are only deductible against income related to that activity. Additionally, assets held in an s-corp are not eligible for a step-up in basis upon the death of a shareholder. This means that the beneficiary or buyer will pay tax on a larger gain because the base value is not adjusted.
Finally, s-corps cannot retain their earnings tax-free. S-corps must make distributions at the end of each year to all of their shareholders who then must pay taxes on the distribution. Basically, S-corps are a bad option for real estate because when an asset is placed in an S-corp, it is stuck there and cannot be taken out without paying capital gains tax. Owners are forced to pay this tax at the end of each tax year without an option to defer.