Real estate investors sometimes think about using S corporations for real estate investing. And the idea sounds promising. Almost everybody knows that S corporations are popular. And many people even vaguely know S corps deliver some big tax benefits to small businesses.
Unfortunately, while many real estate investors do put real estate inside their S corporations--sometimes even setting up S corporation especially for the purpose of real estate investment--the gambit doesn't make sense for at least four reasons:
No Benefit to Using S Corporation
The first reason you shouldn't put real estate inside an S corporation? Simple. S corporations don't deliver special or extra tax benefits to real estate investors.
Income and deductions within an S corporation retain their character as they pass through the S corporation and flow onto the S corporation owner's tax return. Accordingly, an S corporation doesn't let you avoid the passive loss limitation rules (which often trip up real estate investors). And the S corporation doesn't increase the number of tax deductions you get.
Note: If you're concerned about limiting your legal liability, you don't need to use an S corporation. You can use a limited liability company.
Forces an Extra, More Complicated tax return
One thing putting real estate inside an S corporation does do? A real estate investment S corporation automatically forces you to do an extra, more complicated tax return.
Here's why I say this: A real estate investment that you personally own or that you own through an LLC can be handled on a simple schedule E form that's part of your regular 1040 tax return.
Unfortunately, if you own the exact same investment inside an S corporation, you'll need to file a full-blown S corporation tax return. The S corporation tax return will annually cost you at least several hundred dollars--and maybe even a bit more. Yikes.
May Trigger More Complicated Accounting
You what else happens when you put real estate inside an S corporation? Very probably, you'll be forced to use a small business accounting system like QuickBooks. Why? Because when you do your S corporation tax return, you'll need to include not just statements of income and deductions in your return. You'll also need to include balance sheets at the start and at the end of the year.
Checkbook programs like Quicken will produce statements of income and deductions. No problem. But you'll probably need to buy, learn and then use a full-fledged small business accounting system to produce good balance sheets if you're doing your real estate investing inside an S corporation.
Note: Technically speaking, an S corporation doesn't need to include balance sheets with its corporate income tax return until the corporation's assets exceed $250,000. In some areas of the country, accordingly, a small real estate investor might be able to own one or more properties and not tip over this threshold. In many parts of the country, however, a single property will cost more than $250,000 and, therefore, will mean balance sheets are required if the investment is stored inside an S corporation.
Limits Your Depreciation Write-offs
A real estate investment S corporation will also often limit your depreciation write-offs. The S corporation tax accounting rules that create this limitation are complicated to describe. But in a nutshell, when individuals and partnerships borrow money to purchase the real estate, they may be able claim tax write-offs for depreciation on the owner tax returns.
Note: There are rules which limit these so-called passive losses. But if you can trick your way around the passive loss limitation rules--and maybe people can--you can use the depreciation as a tax deduction on your personal return.
So here's the problem with an S corporation: You can't get tax deductions for things the S corporation borrows money for. If the S corporation purchases the real estate using a mortgage, for example, the S corporation's shareholders probably won't be able claim the depreciation loss.
The reason for this is that you don't get credit (or what tax laws call "basis") for loans other people make to the S corporation. You only get credit (basis) for money you invest in the S corporation or money you lend. And you need basis to claim the deduction.
Note: S corporations and their shareholders can use back-to-back loans to get basis. With back-to-back loans, the mortgage company first loans to the shareholder and then, second, the shareholder loans to the S corporation. Then the S corporation buys the real estate with the "mortgage" from the shareholder. This approach, which often works with non-real estate loans, usually doesn't work with mortgages. The bank wants to have a first-row security interest in the property.
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Seattle area CPA Stephen Nelson serves entrepreneurs, real estate investors and other individuals with complex taxes and finances. A best-selling author of books about Quicken and QuickBooks, Nelson also edits the S Corporation Explained and Limited Liability Company Explained web sites.
» left by Anonymous (40 minutes ago.) New Comment!
This is article is helpful in creating fear of generating true wealth - and it also perpetuates the true underlying problem in america today - understanding money - you'll have to do more paperwork and understand how assets and liabilities function and maybe even learn some basic money management software? Wow, sounds like too much work for me - better just stick to paying the most amount of taxes and not having to tax my brain. This is what the truly rich do that the middle class don't - understand the system and how to work within in it to minimize what you pay out - exactly what a corporation can do - it is well worth paying a competent accountant to handle your paperwork and save you tons of money with a corporation than to give it all to the government just so you don't have to fill out too many pieces of paper or learn a vital skill. Too many people work for their money rather than have their money work for them. This article just reinforces the fear factor and keeps the middle class exactly where they are
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