Think Twice Before Purchasing Real Estate in an S-Corporation

By Connor Inlow, Esq.

At first glance, it may seem convenient to purchase or transfer real estate through an S-Corporation—especially if that entity already exists or is active in another business. But real estate investors and business owners should exercise caution before using an S-Corporation to hold appreciating real property. While there are no legal restrictions against holding real estate in an S-Corporation, there may be significant tax and estate planning pitfalls that may not become apparent until it is too late. This article provides an overview of some common tax and estate planning consequences that arise when real estate is placed into a S-Corporation.
This article is for informational and educational purposes only and does not constitute legal or tax advice. The information provided is general in nature and may not be applicable to your specific situation. It is essential to consult with a qualified attorney or CPA licensed in your jurisdiction for personalized legal guidance based on your specific circumstances.

 

Limited Liability Company and S-Corporations, Generally.

Both LLCs and S-Corporations provide limited liability protection to their members or shareholders, as applicable, meaning members or shareholders are not personally liable for the debts and obligations of the LLC or S-Corporation beyond their investment. In addition, both LLCs and S-Corporations allow pass-through taxation avoiding the double taxation that applies to C-Corporations. However, to qualify for S-Corporation status, the corporation must meet the following requirements:
• Be a domestic corporation
• Have only allowable shareholders – may be individuals, certain trusts, and estates
• May not be partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

If you fail to comply with the requirements of being an S-Corporation, you can have your S-Corporation status revoked, risking double taxation as a C-Corporation. Given the strict S-Corporation requirements, LLCs are advantageous for real estate ownership because they allow for fewer formalities and flexibility in management and structure depending on the needs of the business. This flexibility makes LLCs particularly suitable for real estate ventures, as they can accommodate complex ownership structures, including those with foreign investors or centralized management.

 

Transferring and Removing Real Estate From an S-Corporation May Be Costly.

While transferring real estate into an S-Corporation is again permissible, the Internal Revenue Service treats the transaction as if the corporation “purchased” the property at its current market value, triggering a taxable gain for the transferring party, if the transferring party owns less than 80% of the voting power in the S-Corporation after the transfer. This means any appreciation in the property’s value since its original purchase could be subject to capital gains tax. (See I.R.C. § 351 and I.R.C. § 368.)

Likewise, removing appreciating real estate from the S-Corporation may trigger a significant, unexpected tax event. This is because if a corporation distributes property to shareholders in a distribution, and if the fair market value of such property exceeds its adjusted basis, then gain shall be recognized as if such property were sold to the distributee at its fair market value. (See I.R.C. § 301 and I.R.C. § 311.)

This means that if a piece of real estate increases in value during the time it is held in the S-Corporation, distributing it to shareholders will likely result in capital gains tax liability on the appreciated value. By contrast, LLCs taxed as partnerships generally allow real estate to be transferred in or distributed to members without immediate tax consequences, giving them far greater flexibility in estate and tax planning.

 

S-Corporation Assets Do Not Receive a Step-Up in Basis.

Another important limitation of S-Corporations involves estate planning. Upon the death of an S-Corporation shareholder, the shareholder’s heirs receive a “step-up” in basis to the fair market value of the stock at the date of the deceased’s death, but this “step-up” does not apply to the underlying assets owned by the S-Corporation—including any appreciating real estate.

This distinction has major implications for families intending to pass real estate down to the next generation. The heirs may face capital gains taxes on the full appreciation of the real estate if the asset is later sold—even if the stock basis has been stepped up.

In contrast, LLCs taxed as partnerships can elect under Section 754 of the Internal Revenue Code to step up the basis of its underlying assets upon death or transfer of interest. The goal is to align the LLC’s basis in its assets (inside basis) with the member’s basis in their interests (outside basis).

Parties should carefully consider whether a Section 754 election aligns with the overall estate plan and tax benefits. In some cases, the election may not provide a significant benefit, particularly if the assets are not expected to be sold or depreciated and it can be difficult to revoke. However, for estates involving real estate or other depreciable property, the election can provide valuable tax savings.

 

Final Thoughts and a Strong Recommendation.

While every situation is different, we strongly encourage clients considering holding real estate in an S-Corporation to seek the advice of legal counsel and a qualified CPA before making any transfers or purchases. The tax and estate planning implications can be significant and irreversible.

For clients with existing corporations that already hold real estate, it may be worth exploring restructuring—potentially through an LLC—which could provide greater flexibility, estate planning benefits, and reduce long-term tax liability. But again, any such move requires careful coordination and weighing of the tax consequences.
If you have questions about your business or real estate holdings and would like legal guidance tailored to your goals, please do not hesitate to contact us at TLD Law.