Introduction: Never Put Real Estate in an S Corporation*
I will say it again: Never put real estate in an S Corporation. There! Now the kicker: Lawyers are trained to never say “Never” and never say “Always”. Because there is always an exception and there is never a situation where an exception doesn’t exist. We get paid to find those exceptions. Even on the bar exam or law school exams, nine times out of 10 answer choices with those words are wrong. But the title of this post gives one such absolute: Never Put Real Estate in an S Corporation Without First Talking to a Tax Attorney or Tax Accountant. Choose a Partnership. Accept this advice as truth on its face and you’re done. Congratulations. Go back to your beverage of choice.
For those of you who are skeptical, or too curious for your own good, read on – but be warned: we’re going to dip our toe into the weird and wonderful nuances of partnership taxation. The advantages of partnership taxation are many and highly beneficial. But the details of the partnership tax regime are not for the faint of heart. The reason real estate belongs in a partnership is how partnerships are taxed versus the how non-partnerships are taxed. This isn’t an article about what an S corporation is, but for a quick brush up, please watch this video. (If you’re still confused about LLC’s, S-Corps, etc., see our prior post on the difference between the type of legal entity and an entity’s tax status).
*Note: Without first talking to a Tax Attorney or Tax Accountant
Partnership Tax is a Complex, Difficult Area
While partnerships have wonderful advantages over other entities, a Tax Court judge famously wrote in a partnership tax opinion:
The distressingly complex and confusing nature of the provisions of the [partnership section of the Internal Revenue Code] present a formidable obstacle to the computation … without the expenditure of a disproportionate amount of time and effort even by one who is sophisticated in tax matters with many years of experience in the tax field.… Surely a statute has not achieved “simplicity” when its complex provisions may be confidently dealt with by at most only a small number of specialists who have been initiated into its mysteries. David A. Foxman, 41 TC 535, 551 n.9 (1964).
The heart of the difficulty with the mechanics of partnership taxation results from the muddled attempts by courts and legislatures to deal with two competing views of partnerships: the Aggregate View and the Entity View. Congress is well aware of this confusion, and seldom helps to resolve any of it.
Entity vs. Aggregate
Under the Aggregate View, a partnership is an aggregation of individuals. Each individual partner has an undivided interest in all partnership attributes: business, assets, liabilities, income, expenses, deductions and credits. The partnership is a conduit. These attributes “pass-through” the partnership to each individual partner. Partners, not the partnership, pay tax on these attributes.
Under the Entity View, the partnership is a separate, distinct legal entity from the partners. The amount and character of partnership income as well as elections are determined at the entity level.
Both views explain the overall nature of partnerships. But these twin themes intertwine themselves throughout the partnership tax code provisions with some based on the Aggregate View and others based on the Entity View.
Differences Between Partnerships and S Corporations When Holding Real Estate
Both partnerships and S-Corporations are pass-through entities for tax purposes. This means only the individual owners are taxed, not the entity itself. But the similarity quickly ends there as state law and tax law each quickly add many differences between the two. Most of these differences are beyond the scope of this post. Instead, I’ll focus on three of them (there are more) highlighting the basic reasons real estate belongs in a partnership.
Debt Shields Partnership Distributions from Tax.
One of the reasons real estate is attractive as an investment is that it has the potential to appreciate, meaning increase in value beyond the price paid. Basis is approximately equal to the investor’s cost. Gain is the difference between Basis and the price paid. The price paid represents the current level of appreciation, but in any event, represents the amount of appreciation the seller can capture at sale. Here’s the key difference between partnerships and S Corporation with this calculation of gain: debt increases the cost basis of partnership property by the amount of the debt, but does not increase the basis of S Corp. property.
Debt shields the gain from tax on distribution of the real estate to the partners but not to shareholders who place real estate in an S Corporation. Debt also shields cash distributions to partners up to the amount of this combined basis, but does not with S Corp. shareholders. This is true even if the S Corp. shareholders personally guarantee the debt. Since real estate investments are typically leveraged with debt, these basis rules give a huge advantage to holding real estate in a partnership. Note that relief from debt triggers tax consequences in some circumstances.
Future Options to Transfer the Real Estate and Defer Tax of Partner Gain.
Let’s say the owners have held the real estate for a while and it appreciated nicely. Now the owners want to sell the business that’s operating on the real estate or they want to go their separate ways (retirement, or just different future paths). Any course of action by S Corp owners will result in tax on the real estate in an S corporation, directly or indirectly, at the time of the transaction (sale of the business including the real estate, sale of the real estate separately, distribution of the real estate to the shareholder owners).
Partnerships give the partners multiple opportunities to transfer the property (for example: distributions to the partners or 1031 exchanges) that defer taxation to a future date of choice by the individual partners. This is because distributions of real estate from an S Corp. to its shareholders trigger tax on the gain at the time of distribution. Distribution of the real estate from a partnership to its partners does not trigger gain on distribution. The tax is deferred until sale of the real estate by the individual partners. This possible deferral gives many more planning opportunities to the partnership than the S-Corp., including where a buyer of the business doesn’t want the real estate. Note that distributions of real estate subject to depreciation or that has otherwise actually depreciated are more complicated. Advice needs to be sought from your Tax Attorney or Tax Accountant.
No Basis Step-Up Available on Partner Death.
Under federal estate tax law, the basis of assets held by the deceased is increased to fair market value, that is “stepped up” to the amount of the fair value of those assets as of the time of death. Thus, there is no taxable gain on the appreciation of the asset between the date of purchase and the date of death at the time the real estate is sold.
With an S-Corp., the step up in basis is attributable to the S-Corp. stock, not the real estate. This means when the real estate of an S Corp. is later sold, its basis is the original cost. This shifting in basis step up from the real estate to the S Corp. stock decreases tax planning options for the heirs of the deceased in part because the S Corp. shares will generally be harder to sell than the real estate. With a partnership, the basis of real estate is stepped up at the death of the partner, thereby, shielding the appreciation from tax when real estate is sold by the partner’s heirs.
You should consult your Tax Attorney or Tax Accountant as you consider any of these issues. Even if you can’t immediately see how any of the scenarios would apply to you in the future, why would you cut-off the possible later advantages of using a partnership by making the mistake of using an S Corp. now? Answer: You wouldn’t – unless you fail to understand the words in this post. There are no tax advantages of an S Corp. over a partnership when holding real estate.
What Type of Texas Partnership?
If you don’t have someone to be your partner, that’s an issue for your therapist. But your Tax Attorney or Accountant can help you creatively and legally solve this problem for tax purposes. Which type of partnership you should choose in Texas is a business strategy topic for another day. Choices are general partnership (the default and almost never the right choice) or one of: Limited Partnership (LP), Limited Liability Partnership (LLP), or Limited Liability Limited Partnership (LLLP). Please consult your Business Attorney, Tax Attorney or Tax Accountant for advice.
Note: This “Never Hold Real Estate in an S Corporation” advice also applies to C Corporations as well. In addition to the above reasons, you don’t want to also subject your real estate appreciation to C Corp double taxation. Also in some cases a trust may make an appropriate entity to hold real estate to take advantage of certain estate planning strategies. This is also a topic for your Tax Attorney or Tax Accountant.
Start with the assumptions that if you are going to own real estate, you’ll want it to appreciate in value creating gain, and you’ll likely want to leverage your investment with debt. Therefore, the real estate belongs in a partnership.
For more information, contact the professionals at Walker Law PC today. We can help you identify the correct business entity and tax election for your real estate.
John H. Walker