Four Reasons You Don t Want to Put Real Estate Inside an S Corporation
Rental property owners sometimes consider using S corporations to hold their investments And at first look, this idea sort of seems promising S corporations are very popular with non-real-estate small businesses And one hears all the time about all the tax savings that the S corporation delivers . .Sadly, while many people do hold real estate through an S corporation, an S corporation doesn’t make sense for a handful of practical reasons: . .No Benefit to Using S Corporation . .The first reason you shouldn’t put real estate inside an S corporation? Simple S corporations don’t deliver special or extra tax benefits to real estate investors . .Income and deductions within an S corporation retain their character as they pass through the S corporation and flow onto the S corporation owner’s tax return Accordingly, an S corporation doesn’t let you avoid the passive loss limitation rules (which often trip up real estate investors) And the S corporation doesn’t increase the number of tax deductions you get . .Note: If you’re concerned about limiting your legal liability, you don’t need to use an S corporation You can use a limited liability company . .Forces an Extra, More Complicated tax return . .One thing putting real estate inside an S corporation does do? A real estate investment S corporation automatically forces you to do an extra, more complicated tax return . .Here’s why I say this: A real estate investment that you personally own or that you own through an LLC can be handled on a simple schedule E form that’s part of your regular 1040 tax return . .Unfortunately, if you own the exact same investment inside an S corporation, you’ll need to file a full-blown S corporation tax return The S corporation tax return will annually cost you at least several hundred dollars–and maybe even a bit more Yikes . .May Trigger More Complicated Accounting . .You what else happens when you put real estate inside an S corporation? You will, as a practical matter, need to step up to a real double-entry bookkeeping system like Microsoft’s Office Accounting program or Intuit’s QuickBooks program Why? Because when you do your S corporation tax return, you’ll need to include not just statements of income and deductions in your return You’ll also need to include balance sheets at the start and at the end of the year . .Checkbook programs like Quicken will produce statements of income and deductions No problem But you’ll probably need to buy, learn and then use a full-fledged small business accounting system to produce good balance sheets if you’re doing your real estate investing inside an S corporation . .Note: To be nit-picky, balance sheets are not required components of a corporate tax return until the corporate revenues or assets exceed $250,000 In some areas of the country, accordingly, a small real estate investor might be able to own one or more properties and not tip over this threshold In many parts of the country, however, a single property will cost more than $250,000 and, therefore, will mean balance sheets are required if the investment is stored inside an S corporation . .Limits Your Depreciation Write-offs . .A real estate investment S corporation will also often limit your depreciation write-offs Why this occurs is a little tricky to understand But in a nutshell, when individuals and partnerships borrow money to purchase the real estate, they may be able claim tax write-offs for depreciation on the owner tax returns . .Note: There are rules which limit these so-called passive losses But if you can trick your way around the passive loss limitation rules–and maybe people can–you can use the depreciation as a tax deduction on your personal return . .So here’s the problem with an S corporation: You can’t get tax deductions for things the S corporation borrows money for If the S corporation purchases the real estate using a mortgage, for example, the S corporation’s shareholders probably won’t be able claim the depreciation loss . .The reason for this is that you don’t get credit (or what tax laws call “basis”) for loans other people make to the S corporation You only get credit (basis) for money you invest in the S corporation or money you lend And you need basis to claim the deduction . .Note: S corporations and their shareholders can use back-to-back loans to get basis With back-to-back loans, the mortgage company first loans to the shareholder and then, second, the shareholder loans to the S corporation Then the S corporation purchases the property using the money borrowed from the S corporation owner or owners This approach, which often works with non-real estate loans, usually doesn’t work with mortgages The bank wants to have a first-row security interest in the property .
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