By Dr. James M. Dahle, WCI Founder
Many who get into direct real estate investing wonder how they should take title of the property. They worry about liability and they know that corporations can help protect their owners from liability, so they consider putting the property into a corporation. However, this is almost always the wrong move. Let me explain why.
Why Your Investment Real Estate Should Not Be Inside a Corporation
First, we'll discuss why a corporation is a bad idea, Then, we'll talk about the alternatives.
#1 Double Taxation on a Corporation
The first issue with using a corporation applies only to corporations that have not made an S declaration, i.e. C Corps. S Corps, like partnerships and sole proprietorships, are pass-thru entities. That means all their income is passed to the individual owners to report on their own tax returns and to pay at their own individual tax rates. A C Corporation, however, is not a pass-thru entity. It pays taxes on all of its income at 21% (think that's bad? It used to be 15-39% until the Tax Cuts and Jobs Act of 2018). So how do owners of a C Corporation get money out of the corporation? Well, there are two options.
The first is to be paid as an employee of the C Corp. That income is then taxed at their ordinary income tax rate PLUS any payroll taxes. So that income could be taxed as high as 21% + 37% + 2.9% + 0.9% = 61.8%. (Although to be fair, that salary is a deduction to the corporation.) And that doesn't include any state corporation or personal income taxes. Pretty painful, right?
The other option is a little better. The corporation can pay dividends to the owners of its stock. Qualified dividends are taxed at somewhere between 0%-23.8%. So that income could still be taxed as high as 21% + 23.8% = 44.8%. Plus state taxes. Beats 61.8%, but it's still pretty bad.
It is much better to just have that income passed through to your personal return. Since it isn't earned income, it isn't subject to payroll taxes, so the highest tax rate it is going to be subject to is 37% + 3.8% = 40.8%. Now that is the same way an S Corp is going to be treated as far as taxes, but we'll get into reasons below why even an S Corp is less than ideal for rental real estate.
The first reason, then, to avoid putting your real estate into a corporation, at least a C Corporation, is because it will raise your taxes.
#2 Loss of Depreciation
You know what else does not get passed through when you don't use a pass-thru entity? Depreciation. Yes, the corporation can depreciate the property and use it to offset its rental income. But that is not going to reduce the taxes on the wages or the dividends it pays to you, and you cannot use it against any of your other properties. The IRS also won't care that you have Real Estate Professional Status (REPS) since you don't own the property. You won't be able to use that depreciation against other properties you own personally or in other entities, much less against your ordinary income.
#3 Less Ability to Do Exchanges
In my opinion, the biggest benefit of being a direct real estate investor is the ability to depreciate—depreciate—exchange—depreciate—depreciate—exchange—depreciate—depreciate—die. This strategy avoids the recapture of depreciation and takes advantage of the step-up in basis at death. However, when you own a property with other people (at least other people who are not your spouse), that ability to exchange, at least indefinitely, becomes severely limited. The partnership can do an exchange, no problem. But what if one of the partners doesn't want to do it? What if he just wants to take his cash and spend it or invest it elsewhere? Now you've got a problem. Now the partnership has to distribute its real property to its individual members pro-rata, and they have to do the exchange as individuals. This process is subject to IRS challenges and is not insignificant. If this is difficult as a partnership, imagine how much worse it is as a corporation. The complexity, costs, and IRS challenges likely double.
#4 No Step-Up in Basis at Death
The end of that depreciate—exchange—depreciate—die cycle is to die. That is what provides the step-up in basis. But guess what? Corporations don't die. So there is no step-up in basis. Your heirs basically inherit your basis because they just inherit your shares in the corporation.
#5 Additional Cost
When there is a corporation involved, that corporation has its own costs. There are costs to form the corporation, costs to maintain the corporation, and costs to file taxes for the corporation. All these costs effectively lower the return on your investment.
#6 Additional Complexity
Corporations have regular meetings; have their own separate tax return; and probably have to deal with complex state corporation laws, complex state tax laws, complex federal securities laws, and complex federal tax laws. Time is money, and whether it is your time used to deal with these complexities or someone else's time (who you hire), it is going to cost you something.
#7 Inability to Hire Children
One of my favorite parts of being a business owner is being able to hire my kids. Minor children employed by a business entirely owned by their parents do not owe payroll taxes on their earned income from that business. Few of them make more than the standard deduction ($12,950 for 2022), so they don't usually owe any federal or state taxes on that income either. Plus, if they put the money into a Roth IRA (it is earned money, after all), it is never taxed. At all. That's a pretty great deal and a great way to transfer money tax-free to the next generation (although it must be for legit work and you must comply with all employee laws, such as filing I-9s, W-2s, W-3s, etc.). But guess what kind of business can't do this? That's right, a corporation!
#8 You Cannot Act as Your Own Attorney
Sometimes a landlord needs to go to court to enforce an action against a tenant, such as an eviction. These actions are often for a relatively small dollar amount and the landlord often wins when the tenant doesn't show up. But you know who can't act as its own attorney in a court proceeding like this? That's right, a corporation. A corporation must hire an attorney to represent it. There's an additional cost to that.
#9 Lenders Want a Personal Signature
Most real estate investors have realized that lenders want them to sign their mortgages as individuals, not as a business entity. If you're not careful, your actions can cause the corporate veil to be pierced, eliminating the whole point of using a corporation in the first place. Plus, you're still personally liable for what is likely the investment's biggest liability anyway (its mortgage).
#10 Closely Held Corporation Illiquidity
A closely held corporation is one with just a few shareholders (five or fewer own 50% or more of the business). It isn't publicly traded, either, like Apple or Exxon. So when you want out, it's going to be a lot harder than it would be to sell a few shares of Walmart in your brokerage account. You could have to stay for years until the property is sold and the corporation is dissolved. It can also be difficult to raise additional capital by selling additional shares.
#11 Special Closely Held Corporation Tax Rules
As if the illiquidity wasn't enough, there are some special tax rules associated with closely held corporations. For example, the corporation can only deduct losses equal to the amount at risk, i.e. the capital and property you contribute to the business. Passive losses can also only be used against passive income. So, if the corporation has both rental activity and retail activity, losses on the rental side cannot offset income on the retail side. A closely held corporation that wants to donate more than $500 to charity is also required to file a special tax form (Form 8283).
#12 Additional Audit Possibilities
You can be audited as an individual. Your business entities, such as partnerships or corporations, can also be audited. As the old Doublemint Gum commercials go: Double the Pleasure, Double the Fun.
Other Methods of Titling Property
I hope I've convinced you that you do not want to own rental property as a corporation, especially a C Corporation. So what are the other methods and their advantages and disadvantages? Let's go through a few.
Owning Property with an Older Family Member
One of the dumber ways to own property is to own it with your parent (or worse, great-grandparent). Lots of people mistakenly do this thinking it will facilitate estate planning. If you and your mom own her house jointly (Joint Tenancy with Rights of Survivorship), you get the entire house when she dies. Easy peasy, right? Sure. But what are you giving up? You're giving up that step-up in basis at death. Imagine that mom bought the house 60 years ago for $150,000 and it is now worth $1.5 million. Now, you want to sell it. If you owned it jointly, you'll owe tax on $1.35 million in capital gains (you could reduce this by $250,000 if you live in it for two years first). If you merely inherited it, you owe no tax at all. Far better for your mom to own the property outright and for you to inherit it, at least from an income tax perspective.
Owning Property as a Partnership
Some of the downsides of owning a property as a corporation also apply to partnerships. People generally go into partnerships to buy properties because they cannot do it themselves, either because they lack the money or they lack the expertise to do it. If you're in that situation, you may not have a choice. A classic example is a real estate syndication. Maybe 99 different investors buy an apartment complex. None of them have the money to do it themselves. These deals are often limited partnerships, so the liability of the investors is limited to just what they put into the deal, and the manager, called the general partner, gets paid something extra for doing all the work and taking on the additional liability. Downsides include difficulty with exchanges, an additional tax return, and illiquidity issues. And if we're just talking about a regular partnership and not a limited partnership, the liability is also unlimited.
Owning Property as an Individual
There is a lot to be said for owning a property as an individual. You have minimal hassle with the business structure and tax returns, and you have maximum flexibility to do exchanges. If your only partner is your spouse, this also applies. The only real downside is liability. If you are sued by a patient way above policy limits and forced into bankruptcy, you could also lose this property (external liability). If someone slips and falls on the property (internal liability) and obtains a judgment way above policy limits, you could lose the property AND all of your personal assets.
Limited Liability Company
A limited liability company (LLC) is another popular way to own rental property, primarily for liability reasons. LLCs can be taxed as a sole proprietor, a partnership, an S Corp, or a C Corp. Like a corporation, an LLC provides internal and external liability protection. These protections are governed by state law and obviously are higher in some states than others. It provides internal protection by separating your personal assets from those of the business, so only the property is at risk in a severe liability situation. It may provide external protection by limiting personal creditors to a “charging order” against the LLC, meaning when the LLC distributes income, it must go to the creditor.
There is no law requiring an LLC to distribute income to its members, but as a pass-thru entity, taxes must be paid each year, even on retained earnings. So in effect, the creditor can be sent a tax bill without ever getting the income with which to pay it. This can force creditors to the negotiating table and create a favorable settlement.
In many states, a single-member LLC may not receive the same amount of protection as a multi-member LLC. In this respect, Florida and New Hampshire are bad, and Wyoming, Delaware, and Nevada are good. In addition, if the only members are spouses, that protection may also be limited (especially in a successful lawsuit against both spouses). But clearly, if you are going to own property with a non-spouse in a partnership, form an LLC. Otherwise, the LLC may or may not be worth it to you. Either way, make sure you carry plenty of liability insurance, your first line of defense in any asset protection scenario.
To maximize internal liability asset protection, each property should be put into its own LLC. This can be expensive and involve additional hassle. Some states allow a “serial LLC” structure to help minimize both.
The Bottom Line
As a general rule, rental property belongs in LLCs, not corporations, and those LLCs should be taxed as sole proprietorships or partnerships. If a rental property is put into a partnership (such as a typical syndication), it should at least be a limited partnership. However, owning a property as a sole proprietor or in partnership with your spouse is certainly a reasonable thing to do. Just realize you may be giving up a little liability protection (especially if you had instead put that LLC in Wyoming, Delaware, or Nevada) to minimize cost and hassle.
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What do you think? How do you own your rental property and why? Comment below!