S Corp or LLC for Rental Property?
When holding rental property, the S Corp structure has tax limitations that are not immediately obvious. Compare it to an LLC to make an informed decision.
Choosing a business structure is a foundational decision for any real estate investor. The selection between a Limited Liability Company (LLC) and an S Corporation (S Corp) for holding rental property involves analyzing liability protection, tax consequences, and administrative requirements. Each structure offers a distinct framework that can impact an investor’s financial outcome and operational responsibilities. This choice is a strategic decision with lasting effects on asset protection and tax efficiency.
Understanding the LLC for Rental Property
A primary reason investors choose a Limited Liability Company is for the liability protection it affords. An LLC is a legal entity formed at the state level that separates your personal assets from the business’s debts and legal liabilities. If a tenant were to sue over an issue at the property, the lawsuit would be against the LLC, and your personal home, car, and savings would be shielded.
The tax treatment of an LLC is flexible. By default, a single-member LLC is considered a “disregarded entity” by the IRS, meaning its financial activity is reported on the owner’s personal tax return using Schedule E of Form 1040. A multi-member LLC is taxed as a partnership, requiring the filing of Form 1065, with profits and losses passed through to the members to report on their personal returns.
A significant tax advantage of an LLC is the ability to contribute appreciated property to the company without it being a taxable event. If you own a property that has increased in value, you can transfer it into the LLC without immediately owing capital gains tax. This allows investors to structure their assets for liability protection without incurring an upfront tax cost.
The way debt is treated in an LLC structure is beneficial for real estate investors. When the LLC takes on a mortgage to acquire a property, that debt increases each member’s basis in the company. A higher basis allows the member to deduct larger business losses, which are common in the early years of a rental property due to depreciation. For example, if you have a $20,000 loss but your basis is only $10,000, you can only deduct $10,000. The mortgage debt included in an LLC basis makes it more likely you can deduct the full loss.
Understanding the S Corp for Rental Property
An S Corporation is a tax election, not a legal business entity. A business must first be an LLC or corporation and then file Form 2553 to be taxed under Subchapter S of the Internal Revenue Code. This election presents considerable disadvantages for investors whose primary business is holding rental property.
One hurdle involves contributing property to the corporation. Transferring appreciated property into a corporation before making the S election can be a taxable sale unless the strict requirements of Internal Revenue Code Section 351 are met. This rule requires the person contributing the property to own at least 80% of the corporation’s stock immediately after the transfer.
The most significant drawback of using an S Corp for rental real estate is how debt affects a shareholder’s basis. Unlike an LLC, a mortgage on a rental property does not increase a shareholder’s stock basis. This limitation severely restricts the amount of rental losses a shareholder can deduct, as deductions are trapped at the corporate level until the shareholder increases their basis by contributing more cash or making a direct loan.
The “reasonable compensation” rule, which requires S Corp owners who provide services to pay themselves a salary, is also not applicable to passive rental income. This removes the main incentive for making the S Corp election in the first place.
Direct Comparison for Rental Property Owners
When comparing the structures, two differences are paramount for real estate. First, transferring an appreciated rental property into an LLC is a tax-free event, but moving that same property into an S Corp can be a taxable event. Second, and most importantly, is the treatment of basis and the deduction of losses. An LLC member’s basis includes their share of mortgage debt, allowing them to deduct larger paper losses from depreciation, while an S Corp shareholder’s basis does not include that debt, severely limiting this benefit.
Flexibility in distributions also sets the two entities apart. An LLC’s operating agreement can allow for distributions to be made in different proportions than ownership percentages, which is useful for complex ownership arrangements. S Corporations require that all distributions be made pro-rata, in direct proportion to each shareholder’s stock ownership.
The administrative burden associated with each entity differs. LLCs have fewer formal requirements, though an operating agreement is recommended. S Corporations demand more rigorous corporate formalities, including adopting bylaws, holding regular board and shareholder meetings, and documenting those meetings through minutes.
The LLC Electing S Corp Taxation
Investors can have an LLC elect to be taxed as an S Corporation by filing Form 2553. This creates a hybrid structure combining the liability protection of an LLC with the tax rules of an S Corp. While this can be a powerful strategy for active businesses, it is an inadvisable choice for a business that solely holds passive rental real estate.
The primary advantage of an S Corp is the potential to save on self-employment taxes. However, rental income is passive and not subject to these taxes to begin with. Therefore, making the election provides no new tax savings to offset the limitations it imposes.
An LLC that elects S Corp status becomes subject to the restrictive S Corp basis rules. The mortgage debt on the rental property will no longer increase the owner’s basis, which severely limits the ability to deduct rental losses. The structure also imposes the rigid pro-rata distribution rules and increased administrative formalities of a corporation.
There are niche scenarios where this structure might be considered, such as for a large-scale real estate operation with substantial active business activities like property management or development. In such cases, an S Corp election might help manage the tax liability on income from those services. For most investors holding properties and collecting rent, an LLC taxed as a sole proprietorship or partnership is the more advantageous choice.