Should I Put My Rental Real Estate into a Corporation or an LLC?

Let’s look at what happens if you put the properties into a Corporation.

Well, nothing really happens when the properties are held within a corporation during the holding period. However, you will have more stringent reporting and compliance requirements. You will find it hard to do tax planning for the future.

It’s at the time of selling or moving the property, basically when you’re moving it in or out of the corporation that you will face problems. It’s because you will trigger taxable events in both situations.

Q. What happens while I’m transferring a property into a Corporation?

While transferring appreciated real estate into a corporation, it causes the person transferring the property (the transferor) to recognize those capital gains.

As a reminder, Capital Gains = Fair Market Value Less Tax Basis of the property. The Tax Basis of a property is calculated as = Cost + Any Improvements Made – Accumulated Depreciation.

However, you can avoid triggering a capital gain situation at the time of transferring appreciated property into a corporation. It is also known as the capital gain recognition exception. As per the rule, if the taxpayer controls (read owns) more than 80% of the corporation’s stock immediately after the transfer of real estate, he might be able to avoid a capital gains situation.

“Control” can also apply to groups. If you and your partner contribute property to a corporation in return for a 50-50 ownership, you won’t have to recognize gain on your appreciated rental real estate property.

This means, you as an individual do not need to own 80% of the corporation after or at the time of transfer of property. As long as another person or persons transfer appreciated property to the corporation at the same time as you and your combined interest in the corporation exceeds 80%, then you control the corporation as a “group.”

Assuming that you qualified on the basis of the control exception, the capital gain still doesn’t disappear. Instead, your share value of the corporation stock will be equal to the tax basis of the contributed property. So whenever you decide to sell the property or the corporation stock, you will be taxed on that gain.

Additionally, if the property being transferred into the corporation is subject to a liability, as is the case with most real estate, we have more problems. If the corporation assumes the liability from the transferor, then the transfer will trigger a gain in the amount that the liability exceeds the tax basis of the asset.

Q. What happens if I transfer rental real estate out of a Corporation?

It immediately becomes a taxable event.

#1 If a C-Corp sells real estate (hopefully, it has appreciated in value over time), the corporation will have to pay a flat 21% tax on the gain.

#2 Remember that the money from the sale is still held by and within the corporation. To get the money out, the owners must pay tax on their dividend income which could be up to 20% or more. Reminder, if the corporation continues even after the sale, the owners must pay a tax on their dividend income.

By now, you’ve realized that the gains from the sale of a property that is held within a corporation will trigger a double taxation event.

When you transfer property within a corporation to owners, you will have either a non-liquidating or a liquidating distribution. Non-liquating distribution is also known as current distribution.

With a current (non-liquidating) distribution, the corporation will treat the transfer as if the corporation sold the property at the fair market value. This means that the corporation will pay tax then and there on the capital gains made which is at the time of selling the property.

A liquidating distribution is a little different, but you don’t get spared from its bad tax consequences either. The corporation will again treat the transfer as if the property was sold and will pay tax on the resulting gain. But because the corporation is no more, the owners will also recognize gain on the difference between the fair market value of the property received less liabilities (any debt) assumed by the owner and the owner’s basis in the corporation’s shares.

Q. Is an S-Corporation any Different from a Corporation when it Comes to Holding Properties?

The rules are pretty much the same with S-Corps except for the fact that an S-Corporation is a pass-through entity. As a result, an S-corporation is not subject to the double taxation that a C-Corporation is. While an S-corporation wouldn’t have to pay tax twice to get real estate out of the corporation, it still can’t move property out of the corporation without triggering a sale.

LLCs are therefore the perfect solution. They provide more flexibility. Moving real estate in and out of a partnership LLC or a single-member LLC is simple and does not come with disastrous tax consequences.