Here’s why you should think twice about using a C corporation for rental real estate property.
In practice I have encountered legacy entities that were set up before the rise in popularity of S Corporations or the general acceptance of Limited Liability Companies. Occasionally, there is still the investor who was advised to purchase or is contemplating purchasing, rental real estate in a C Corporation. Utilizing a C Corporation as an entity choice could prove costly.
Real estate and double taxation
A C corporation is not a pass-through entity. Corporate taxable income is initially taxed at the entity level. If the corporation distributes its earnings to shareholders as a dividend, the recipient of the dividend must include it in his or her individual income tax return, where it is again subject to tax.
Individuals invest in real estate for its current income (cash flow) and future value (appreciation). If real estate appreciates in value while owned inside a C corporation and the asset is sold by the corporation, the gain will be taxed at the corporate level at corporate income tax rates. If the C corporation then makes distributions to its shareholders as a dividend, the recipients must include the dividends, where it will be subject to a second level of tax.
Getting real estate out of C corporations
Property owners may hold real estate inside a C corporation because they desire liability projection. It is also possible the entity was inherited from a family member and it already held title to the real estate. The limited liability protection can be offered by the use of S Corporations and Limited Liability Companies (“LLC”), which provide the liability protection of a corporation without the double taxation.
There are options available to address real estate owned by a C Corporation that include:
- Distributing the property in kind to the shareholders.
- Selling the real estate to the shareholder or an unrelated party
- Converting the C Corporation into an S Corporation.
Distributing appreciated real estate to shareholders
A corporation that transfers a real estate deed to one or more shareholders has made a “deemed sale” that is taxable to both the corporation and the shareholders (assuming a non-liquidating transaction). At the corporate level, the distribution is treated as a sale to the shareholders at fair market value. Corporate gain is calculated as the excess of fair market over the corporation’s basis in the real estate. The shareholders that receive the property will be taxed on the full amount of the distribution. If the corporation has current or accumulated earnings and profits, the distribution is treated as a dividend.
Selling appreciated real estate
The sale of the real estate is a taxable event to the corporation. Unlike a “deemed sale” mentioned above, an actual sale generates cash for the corporation to pay the resulting tax. If the proceeds from the sale are not distributed to the shareholders, there will be no tax to the shareholders (along with no cash).
Converting a C corporation into an S corporation
Shareholders can convert a C corporation into a subchapter S Corporation. Unlike the first two options, this can completely avoid double taxation. However, there are potentially costly tax issues that should be addressed including:
- Built-in gains (“BIG”) tax – if an S Corporation that was formerly a C Corporation sells appreciated real estate, the entity may still pay C Corporation taxes on the appreciation.
- Excess passive investment income – S Corporations that were formerly C Corporations with passive investment income (which includes rents) in excess of 25% of their gross receipts are assessed a corporate tax at the highest corporate rate.
I will discuss converting from C Corporation to an S Corporation in a later blog post.