The answer is that it’s best to hold rental real estate either in your own name, or in an LLC. That’s the bottom line answer, but if you would like to learn about the specifics, read on.
Why is it not a good idea to hold real estate in an S corp?
The primary reason you would want to operate a business inside an S corporation is because you can avoid paying self-employment tax on the portion of the corporate income above a reasonable wage. But rental income isn’t subject to self-employment tax anyway.
But there are disadvantages. A major disadvantage is that it’s a taxable event to move the property into or out of the S corp. You’ll need to pay capital gains tax on the difference between your tax basis for the property and the current fair market value if you move it into or out of the S corp. You also can’t take advantage of some of the tax benefits of owning real estate in your own name, including qualifying for a stepped up basis for your heirs if you pass away.
There are situations where it can make to use an S corp for other activities related to real estate, such as flipping houses or developing raw land for future sale. But that’s a different scenario with different tax treatment than operating a rental property.
Why is it not a good idea to hold real estate in a C corp?
A C corporation has the same issue as an S corp when it comes to moving the property into or out of the corporation. It’s a taxable event to move the property into or out of the corporation, and you’ll need to pay capital gains tax on the difference between your tax basis for the property and the current fair market value. So once it’s in the corporation, your options with it are limited. For example, you couldn’t do a 1031 exchange into other investment properties held outside the corporation.
But what’s worse with a C corp is the way your rental income is taxed. If the rental is profitable, or if the corporation sells the property at a profit, the profit is taxed at the corporate tax rate (currently 21%), but then you additionally have to pay personal taxes on that income again if you take it out of the corporation as a distribution.
It’s generally recommended that you avoid putting real estate in a corporation in most cases, except when the primary business of the corporation is an activity other than rental real estate, there are situations along those lines where it can make sense.
Is it better to hold rental real estate in your own name or in an LLC?
It’s best to either own rental real estate in either your own name, or in an LLC.
A single member LLC is completely disregarded for federal tax purposes. There are no tax benefits (or disadvantages) to holding a rental property in an LLC vs. your own name. The reason why people choose to put a property in an LLC isn’t for tax reasons, but for the possibility that an LLC may offer at least some liability protection for your other assets if someone sued the LLC.
What about trusts?
You may choose to put a rental property in a revocable trust, but these types of trusts are transparent for tax purposes, so this won’t affect your taxes at all.
You may want to put a rental property in a living trust so it can more easily pass to your heirs when you’re no longer alive. In some cases, some people may also choose to use a structure involving a trust to make it more difficult for other people to see what assets you own. The purpose of that may be that if someone is contemplating suing you, it makes it more difficult for them to determine if you have enough assets to make it worth the effort to sue you. But these are topics that are unrelated to your taxes and would be something you would want to talk to an attorney about if you believe that’s something you may need.
You may see people online promoting a trust structure that lets you avoid taxes, such as capital gains. They are likely promoting a tax scheme involving a complex spendthrift trust. Using that type of trust for the purpose of tax avoidance is generally not actually allowed under tax law, and the IRS has been increasingly going after taxpayers and promoters who try to use that type of tax scheme.
When do you need a partnership?
If more than one person owns the property, or if you want to operate the rental property as a shared business together with another person, you’ll need a partnership. One notable exception is that you don’t need a partnership if the other person is your spouse and you live in a “community property” state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin).
When you are a partnership, you’ll need to file a 1065 partnership tax return each year. It’s due March 15th (one month earlier than your personal return). And the IRS penalties for a later partnership return are steep, so don’t miss the deadline (you can file a 6 month extension).
