7 Reasons to Keep Real Estate Out of your Corporation

By Dawn Winstead, CPA, CFP®

One of the most important decisions you will make when investing in real estate is what type of entity should hold the assets. Many investors use corporations to hold their real estate because of the liability protection. However, holding real estate in a corporation is a big mistake for tax purposes.

Here are just a few reasons you should think twice about holding your real estate in a corporation:

1. Double taxation for C corporations. When you sell appreciated assets in a C corporation you will be hit by double taxation on the gain. The company will pay tax on the gain when the property is sold, and then the shareholders will pay tax on the proceeds once they are distributed out.
2. Franchise tax (certain states). As your real estate appreciates, so will the yearly tax.
3. No favorable capital gains rates for C corporations. The 15% favorable capital gains tax rate available to individuals is not available to C corporations. Therefore, any gain on real estate sales will be taxed at the company’s regular tax rate. Currently, the highest rate for C corporations is 35%.
4. No basis step-up for beneficiaries. When you own assets individually or through a partnership, your family may inherit the assets at their fair market value when you die. They can then sell the assets with minimal gain. However, if they inherit the stock of your corporation, there is no “step-up” in basis for the real estate. The shares of stock will be passed on at fair market value, but not the real estate. It is more difficult to sell the stock of a company than it would be to sell just the real estate it holds.
5. Loss limitations with an S corporation. S corporation shareholders do not receive debt basis for loans made by a third party to their corporation like partners in partnerships do. The only way the shareholders can acquire debt basis is to personally make loans to the company. Since basis (both stock and debt) determines the taxation of distributions and the deductibility of losses, not receiving basis from third party debt is a major disadvantage for S corporations holding real estate. S corporations cannot refinance their properties and distribute the proceeds to the shareholders tax-free unless the shareholders have sufficient basis.
6. Built-in Gains Tax (BIG). When a C corporation that owns appreciated assets converts to an S corporation and then sells those assets at a gain within 10 years of the conversion, the corporation will be charged the BIG tax at 35%. The calculation of the tax is quite complicated and can be affected by other things, including the corporation’s taxable income.
7. Personal Holding Company Tax (PHC). A C corporation with rental income may be charged the PHC tax if it does not make regular dividend distributions to its shareholders. The PHC tax is at a 15% rate and it is computed in addition to the company’s regular income tax.

If you are planning on making a real estate investment, extra care should be taken to decide upon what the appropriate entity structure should be. Typically the ideal entity to hold real estate will be a Limited Liability Company.