If you are unfamiliar with the LLC or S-corp, please take a moment to familiarize yourself by clicking on the respective hyperlink.

Otherwise, let’s begin.  There are typically two primary questions to address with respect to real estate; first, why should I place my property into an entity instead of just holding it in my personal capacity; second, what is the preferred vehicle for real estate holdings?

1) Why should I place my property into an entity instead of just holding it in my personal capacity?

To answer this first question, the reason most people put their real property into an entity is to limit liability–simple as that. And as why would you need to limit liability when you own property; well there are many reasons, one being that you may want to protect your personal assets from a tenant who is leasing the property and injures himself due to negligence that may be attributable to your oversight. Of course, some property owners just increase their insurance policy limits to protect themselves. However, liability verdicts are uncertain and an entity form in addition to a moderate insurance policy may be the most cost-effective method of shielding personal assets.

2) Is the LLC the preferred vehicle for real estate holdings?

To answer this second question, the reason most people place real estate into an LLC is because it prevents recognition of gain. Assuming there has been an increase in the value of the property, the goal is to transfer the property into an entity in order to limit liability without triggering taxes on the increase. This can be accomplished using an LLC. In fact, even if you later decide to transfer the real estate back to yourself, you will again avoid triggering taxes on the increase. This is often referred to as “carryover basis,” because the basis in the property remains unchanged from that basis which you held in the property. What may come to mind at this moment is a follow up question; specifically, why should I hold my real property in an LLC as opposed to an S-corp?

             a. Why should I form an LLC instead of an S-corp?[1]

LLC or S-corp? Well it depends on what you’re doing with the property. Will the property be used for rental investment purposes or will it be a flip? If you will be dealing with a property that mainly derives rental proceeds, the LLC form is optimal because you get the benefit of not triggering taxes of gain on transfer and the flexibility of custom share allocation to partners. Also, for those concerned with self-employment taxes, rental income is treated as passive investment income exempt from self-employment tax for both the LLC and S-corp. On the other hand, if you plan to flip the property in less than a year (treated as ordinary income), an S-corp would be the optimal choice because it allows you to allocate the profits from the flip between salary and distribution, i.e., you can avoid paying self-employment tax on the distributions. Notably, if you were planning to hang on to the flip property and only sell it after a year has passed, you may get the benefit of paying long-term capital gains taxes instead of higher ordinary rates; here, both the LLC or S-corp would be suitable.

The primary concern with the S-corp form is the likelihood that you will trigger a taxable gain event on appreciation if there is mortgage liability that shifts from you to the entity upon transfer. See 26 U.S. Code §357. An example would involve an owner acquiring property and subsequently attempting to transfer the property and mortgage liability to the S-corp; or, if an owner later decided to move the property out of the S-corp and place it back into his personal name. If these are your concerns, then forming an LLC to hold the real estate may be the best option. All these considerations revolve around a fundamental concept, the time-value-of-money; that is, a dollar today is worth more than a dollar tomorrow. The objective being, delay paying tax on property appreciation for as long as is legally possible.

For those property investors engaging in regular property investing with no other source of income, it is highly advisable that you place the property into an LLC that is taxed as an S-corp. As a practical matter, if you are not transferring mortgage liability to the entity, the risks associated with an S-corp triggering event are nonexistent for an LLC with S-corp tax election. On the other hand, the downside risk of holding property in an LLC without electing S-corp treatment boils down to the following issue.

In the event the IRS decides your investment is a business–that what you’re doing is to earn a living–the property changes from a capital asset to a means of producing income that’s subject to ordinary tax rates, plus the additional burden of another 15.3 percent in self-employment taxes. For the IRS, it’s a facts-and-circumstances test, there’s no rule of thumb that says buy four houses and you’ll get capital gains; buy ten houses and you’re a business. In fact, it may even come down to whether you hold a primary job outside of property investing.

For investors engaging in regular property investing, the upside of keeping your property in an LLC with S-corp taxation is that you essentially get all the benefits of a regular LLC, as provided in 1-3 with the added benefits of 4 and 5 listed below:

1. You can obtain passive rental income;
2. You can sell or flip the property in less than a year and avoid self-employment taxes;
3. You can flip the property after a year and obtain long-term capital gains treatment;
4. An LLC without S-corp election is subject to gross receipt tax on a final sale amount over $250,000 (property sales typically exceed this threshold).
5. In case the IRS audits you and reclassifies your activity as business instead of investment–you can still avoid self-employment taxation on all your gain.

This last advantage is even more critical in light of a recent article published by the Wall Street Journal[2] which found that owners of incorporated businesses vs. business owners who file a schedule C are ten times less likely to be audited by the IRS (based on auditing data and the fact that a single member LLC files a Schedule C, an LLC with one owner faces an increased chance of being audit).

Moreover, in the event that you need to make adjustments and the S-corp election is unfavorable (e.g., you want to transfer it into your name and take advantage of the primary residence exclusion upon resale), you can always terminate the S-corp election and revert to an LLC by preparing a letter to the IRS. The letter should be titled “Revocation of S Corporation Status” and include a statement that the company is terminating the election pursuant to IRC Section 1362(a) (keep in mind that an entity with S-corp election that revoke its “S” status must typically wait five years before being able to re-elect it). This preemptive strategy is only effective if applied in this order. If you try to form an LLC and put off electing S-corp status only in the event the IRS reclassifies your earnings for the past few years as business income–you will not be able to apply the S-corp election retroactively and thus you may be subject to 15.3% self-employment back taxes on all your income for the past few years. Thus, contrary to conventional advice that an LLC is always the best vehicle for real property holdings, as a matter of strategy, forming an LLC and electing S-corp taxation may be the best choice for a property investor who may be engaging in activity that could be viewed by the IRS as business activity.

Notably, for investors who have a blend of both rental investment property and property that they flip, having an LLC with S-corp tax election may be more than adequate instead of maintaining two separate entities such as an LLC for rental investment and an S-corp for flips.

            b. What is a 1031 Exchange?

You can also defer tax on your real estate gain by exchanging it for another property, known as a like-kind “1031” exchange (the asset must be income-producing not a personal asset). You can read more about 1031 exchanges elsewhere, but the essential requirements are; designate up to three replacement properties within 45 days, and close on any one property within 180 days (days run concurrently from date of your original property sale). Keep in mind that a 1031 exchange will only defer your tax bill; when you finally dispose of the investment property you acquired in the exchange, you’ll owe taxes on the entire gain relative to your original basis.

            c. Problems when Transferring Property into the Entity

Another and often times overlooked consideration is whether, practically speaking, the property can be transferred into the entity’s name. The answer to this question has been devastating for some business owners who, after spending time and money forming an entity, come to realize that they can not transfer the property as a practical matter. If you own the property outright, then this consideration is not an issue for you; however, if you have a mortgage on the property you may want to find out whether the agreement has a “due on sale” clause. A due on sale clause typically provides that the mortgage is due in full upon any transfer of title. As you probably suspect, this becomes a real nightmare for most people who are in no position to pay off their mortgage. Moreover, the option of refinancing the property under the entity will most likely fail unless your entity has a solid credit rating and qualifies for a mortgage in its own name. Generally speaking, the bank wants to hold you personally liable for the property mortgage; a transfer could potentially reduce their security interest since they may no longer be able to hold you personally liable. With that being said, some banks do allow this transfer to take place. To avoid needless expense, you should discuss the specifics with your bank prior to forming the real estate entity.

             d. Primary Residence Exclusion

Want to avoid taxes altogether? Move into the investment property and turn it into your primary residence. As long as you live there for two years out of the last five years, the IRS will allow up to $250,000 (double that if you’re married and file jointly) of your profits to be excluded from taxation. If you plan to rent the property out temporarily but anticipate making it your primary residence in the future, placing the property into an LLC is the best choice because you can transfer it back into your personal name later without triggering a taxable event (an LLC electing S-corp taxation would be unwise in this situation).

TIP

Lastly, when flipping properties, make sure you maintain all records and documentation in order to claim real estate investment deductions that will hold up to IRS scrutiny in the event of an audit. In particular, you should provide form 1099-MISC to all independent contractors doing work that exceeds $600 because in the event of an audit, not only will you be subject to penalties of $100 per form (up to $1.5 million for the year) you may also bar yourself from taking the legitimate deduction in the event you have no proof or records. Imagine if you have a relationship where you pay an independent contractor/business a few times a month; the $100 penalty and forfeiture of legitimate but undocumented deductions can quickly add up over the period of a few years. Of course, there is an exception, you don’t need to send a 1099-MISC to a corporation. Additionally, it would be wise to keep separate accounts for each property in order to avoid commingling of associated costs and expenses.