How to Transfer Real Estate Out of an S Corp

An S corporation is a business structure that allows profits and losses to be passed directly to the owners’ personal income without being subject to corporate tax rates. Shareholders may want to transfer real estate out of the corporation for several reasons, including to separate the asset from business liabilities, for estate planning purposes, or to facilitate personal financing on the property.

Key Information and Valuations Needed

Fair Market Value

Before initiating a transfer, the first step is to determine the property’s fair market value (FMV). FMV is the price the property would sell for on the open market. For a real estate transaction of this nature, obtaining a formal, independent appraisal is standard practice to provide an objective valuation for tax purposes.

Property’s Adjusted Basis

The S corporation’s adjusted basis in the property must be calculated. This figure starts with the original purchase price and is increased by the cost of capital improvements, such as a new roof or a significant renovation. The basis is then decreased by any depreciation deductions the corporation has claimed on its tax returns.

Shareholder’s Stock Basis

The shareholder receiving the property must determine their basis in the S corporation’s stock. A shareholder’s stock basis begins with their initial investment and increases with their share of corporate income and any additional capital contributions. It decreases with their share of corporate losses and any distributions they receive. Shareholders calculate and track this basis using Form 7203, which is filed with their personal tax return.

S Corp’s Accumulated Adjustments Account (AAA)

The Accumulated Adjustments Account (AAA) is a corporate-level account that tracks the cumulative, undistributed earnings of the corporation that have already been taxed to the shareholders. The AAA begins at zero when a corporation first elects S status. This account is a factor in determining how distributions are taxed, distinguishing between a tax-free return of capital and a taxable distribution.

Corporate Earnings and Profits (E&P)

Corporate earnings and profits (E&P) are relevant only if the S corporation was previously a C corporation or acquired one. E&P represents the accumulated earnings from the C corporation era that have not yet been distributed to shareholders. The presence of E&P can change the tax treatment of distributions that exceed the AAA balance, potentially causing them to be taxed as dividends.

Tax Consequences of the Transfer

Impact on the S Corporation

When an S corporation distributes appreciated property to a shareholder, the transaction is treated as if the corporation sold the property at its fair market value. This “deemed sale” triggers a gain at the corporate level, calculated by subtracting the property’s adjusted basis from its FMV. This gain is not taxed to the corporation but is passed through to all shareholders on a pro-rata basis according to their ownership percentages.

A portion of the gain may be reclassified as ordinary income if it is from depreciation deductions, which is known as depreciation recapture. If the real estate is depreciable property in the hands of a shareholder who owns more than 50% of the stock, the entire gain is treated as ordinary income.

Distributing Property at a Loss

The tax rules are different if the property has decreased in value. If an S corporation distributes property with an FMV that is less than its adjusted basis, the corporation cannot recognize the loss. It is often more advantageous for the corporation to sell the property to a third party, recognize the loss, and then distribute the cash proceeds to the shareholders.

Impact on the Shareholder

The tax impact on the shareholder who receives the real estate is determined in a sequence. The distribution’s value, which is the property’s FMV, is first considered a tax-free return of capital up to the amount of the shareholder’s stock basis. This reduces the shareholder’s stock basis but is not immediately taxed. Any value that exceeds the stock basis is treated as a capital gain.

The Accumulated Adjustments Account (AAA) is reduced by the FMV of the property distributed. If the S corporation was previously a C corporation and has accumulated E&P, the distribution rules are more complex. Distributions are first sourced from the AAA and are tax-free up to the shareholder’s stock basis. Once the AAA is depleted, any further distribution is considered to come from E&P and is taxed as an ordinary dividend. Any remaining value is a tax-free return of capital against the shareholder’s remaining stock basis, with any excess taxed as a capital gain.

Handling Liabilities

The presence of a mortgage or other liability attached to the real estate adds another layer. If the shareholder assumes the liability, this affects calculations for both the corporation and the shareholder. For the S corporation, the gain is calculated as the greater of the property’s FMV or the liability amount, minus the property’s adjusted basis.

For the shareholder, the distribution amount is the property’s FMV minus the liability they assumed. This net value is applied against their stock basis to determine the tax consequences.

The Corporate and Legal Transfer Process

Corporate Authorization

The first step in the legal transfer is to obtain formal corporate authorization. This is done by drafting a corporate resolution that must be approved by the board of directors and, depending on the bylaws, potentially the shareholders. This resolution serves as the official internal record of the corporation’s decision to transfer the asset. It documents the specifics of the transaction, providing legal clarity and authority for the action.

Executing the Deed

With corporate approval, the next step is the physical transfer of the property’s title by preparing and executing a new deed. The deed is a legal document that transfers ownership from the S corporation (the “grantor”) to the shareholder (the “grantee”). The deed must be signed by an authorized officer of the S corporation to effectuate the change in ownership.

Recording the Transfer

The final step is to record the new deed with the appropriate government office, which is typically the county recorder’s office where the property is located. This public recording provides official notice of the change in ownership. Recording the deed protects the shareholder’s ownership rights and establishes a clear chain of title.

Tax Reporting Requirements

S Corporation’s Return (Form 1120-S)

The S corporation must report the property distribution on its annual tax return, Form 1120-S. The gain from the “deemed sale” is reported on Form 4797, Sales of Business Property, or Schedule D. The distribution itself is also reported on the return. The fair market value of the property distributed is entered on Schedule K, line 16d. The corporation’s balance sheet, Schedule L, must also be updated to reflect the removal of the asset and the reduction in retained earnings.

Shareholder Schedules (Schedule K and K-1)

The information from the corporation’s Schedule K flows to each shareholder’s individual Schedule K-1. The gain recognized by the corporation is passed through to the shareholders based on their pro-rata ownership percentage and will appear on the appropriate line of their K-1. Separately, the property distribution is reported to the specific shareholder who received it in Box 16 of the Schedule K-1, using code ‘D’ for property distributions.

Shareholder’s Personal Return (Form 1040)

The shareholder uses the information from their Schedule K-1 to complete their personal tax return, Form 1040. The pass-through gain from the deemed sale is reported on the appropriate schedule, typically Schedule D or Form 4797, and the resulting tax is calculated. The shareholder must also determine the taxability of the distribution they received, as reported in Box 16 of the K-1. They will compare the distribution amount to their stock basis, and if the distribution exceeds their basis, the excess is reported as a capital gain.