S Corp Rental Property: Tax Rules and Traps

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. While this structure offers liability protection similar to a standard corporation, placing a rental property within it introduces a distinct set of tax rules and potential complications. The journey from placing the property into the S corp to eventually selling it involves specific tax considerations at each stage.

Placing Rental Property into an S Corporation

Moving a rental property into an S corporation can often be accomplished tax-free if it adheres to Internal Revenue Code (IRC) Section 351. This provision allows a shareholder to contribute property to a corporation in exchange for stock without immediately recognizing a gain or loss. This tax-deferred treatment applies provided the shareholder, or group of contributing shareholders, controls at least 80% of the corporation immediately after the transfer.

This transaction establishes the corporation’s basis in the property and the shareholder’s basis in the stock. The S corporation’s basis in the rental property is a “carryover basis,” meaning it takes the same basis the shareholder had in the property. For example, if a shareholder’s adjusted basis in a property was $200,000, the corporation’s basis would also be $200,000, regardless of the property’s current fair market value.

Simultaneously, the shareholder’s basis in their S corp stock is calculated. This initial stock basis starts with the adjusted basis of the property contributed but must be reduced by any debt the corporation assumes. If the rental property had a mortgage of $150,000 that the S corp took over, the shareholder’s stock basis would be reduced by that amount. Using the previous example, the shareholder’s stock basis would be $50,000 ($200,000 adjusted property basis – $150,000 assumed mortgage).

Operating the Rental Property Within the S Corp

As a pass-through entity, the S corp itself does not pay federal income tax. Instead, the net income or loss from the rental activity flows through to the individual shareholders. The corporation calculates this on Form 8825, “Rental Real Estate Income and Expenses of a Partnership or an S Corporation,” which is filed with the main corporate tax return, Form 1120-S.

Each shareholder receives a Schedule K-1, which details their pro-rata share of the rental income, expenses, and deductions, which they then report on their personal tax returns. Common deductible expenses for the S corp include mortgage interest, property taxes, insurance, and repairs. A significant deduction is depreciation, which the corporation claims on the property, reducing the net taxable income passed through to shareholders.

A shareholder’s ability to deduct any losses passed through from the S corp is subject to limitations. A shareholder can only deduct losses up to their stock basis. This basis is adjusted annually; it increases with any additional capital contributions and the shareholder’s share of corporate income, and it decreases with corporate distributions and losses. If a shareholder’s portion of the loss exceeds their basis, the excess loss is suspended and carried forward to future years, becoming deductible only when the shareholder has sufficient basis.

Furthermore, the passive activity loss (PAL) rules apply at the shareholder level. Rental activities are considered passive, which means that even if a shareholder has enough basis to absorb a loss, they can only use that passive loss to offset income from other passive activities. There is a limited exception that may allow up to $25,000 of rental losses to be deducted against nonpassive income, but this benefit phases out as the taxpayer’s income increases.

Shareholder Compensation and Distributions

Extracting funds from an S corporation that holds a rental property involves a distinction between shareholder compensation and distributions, each with different tax treatments. If a shareholder performs more than minor services for the corporation, such as actively managing the property, the IRS requires the S corp to pay them a “reasonable compensation” in the form of a salary. This salary is reported on a Form W-2 and is subject to federal employment taxes, including Social Security and Medicare.

Reasonable compensation is based on what a similar business would pay for comparable services. The IRS scrutinizes this area to prevent shareholders from avoiding payroll taxes by taking all profits as distributions. Failure to pay a reasonable salary can lead the IRS to reclassify distributions as wages, resulting in back taxes, penalties, and interest.

In contrast to salary, distributions are withdrawals of the corporation’s profits. These payments are reported to the shareholder on Schedule K-1 and are not subject to payroll taxes. The taxability of a distribution depends on the shareholder’s stock basis.

A distribution is treated as a tax-free return of capital to the extent of the shareholder’s basis. If a distribution exceeds the shareholder’s stock basis, the excess amount is taxed as a capital gain. For example, if a shareholder with a stock basis of $30,000 receives a $40,000 distribution, the first $30,000 is a tax-free return of their investment, and the remaining $10,000 is taxed as a capital gain.

Selling or Distributing the Rental Property

When the S corporation sells the property to a third party, the gain or loss is calculated at the corporate level. This gain, which includes the recapture of any depreciation deductions previously taken, is then passed through to the shareholders on their Schedule K-1s and taxed on their personal returns.

A more complex scenario arises if the corporation distributes the property directly to a shareholder instead of selling it. This transaction is treated as a “deemed sale” under the tax code. The corporation must recognize a gain as if it had sold the property to the shareholder at its fair market value. This corporate-level gain then flows through to all shareholders, who must pay tax on it, even though no cash from a sale was received.

A consideration for certain S corporations is the Built-In Gains (BIG) Tax under IRC Section 1374. This corporate-level tax applies to companies that were previously C corporations and then elected S corp status. It is designed to prevent C corporations from avoiding double taxation on appreciated assets by converting to an S corp before a sale. The BIG tax is imposed if an asset held by the company when it was a C corp is sold within a five-year “recognition period” after the S election.

The tax is calculated at the highest corporate tax rate on the “built-in gain,” which is the appreciation that existed at the time of the S corp conversion. For instance, if a property was worth $500,000 when a C corp converted to an S corp and had a basis of $300,000, the built-in gain is $200,000. If the property is sold within five years for $600,000, the BIG tax would apply to the first $200,000 of gain. This tax is paid by the S corporation directly, and the remaining gain, net of the tax, passes through to the shareholders.