A couple days ago one of our ADPI members asked the group, “Not sure if I should put my rental properties in an LLC or an S Corp. Any advice?
Such a great question, and so important you understand why we NEVER EVER hold rentals in an S-Corp. So, I’ve developed my list below of the “Top 4 Reasons to NEVER EVER Hold Title to Rental Properties in an S-Corp!” Enjoy…
#1 Estate Planning – One of the greatest generational wealth building tools is the “step-up in basis.” If you buy a property for $300,000 today, and in twenty years the property is worth $1,000,000 when you eventually die, your heirs will inherit the property with a Stepped-Up basis of $1,000,000. Meaning your heirs can inherit the property, sell it the next day, and pay NO TAX. If, however you’re holding title in an S-Corp, your heirs will NOT get the stepped up basis. They would have to pay taxes on $700,000 when they sell.
#2 Dealer Status – If you buy and sell more than one property in year, in the same LLC (or S-Corp) that owns rentals, the IRS can tax you as a “Real Estate Dealer.” Once you’ve been tagged as a dealer, all the passive income is now classified as active income. None of your deprecation losses count. And by the way, because the rents are now considered active income, you owe Social Security and Medicare taxes on the rent you’ve been collecting.
# 3 Tax Problems – The IRS has a little rule called the “25% Passive Income Rule.” If your S-Corp has more than 25% of its income as passive for a period of 3 years, the IRS can convert your S-Corp to a C-Corp. Now you really have problems…
# 4 Taxable Event to Refinance – At some point in the future, as your tenants pay down the mortgage and inflation continues, you’ll start building equity. It’s very common, and very wise, to refinance the property, pull the cash out, and buy more properties. Usually, you’ll get the best financing using your name and your credit. The banker will tell you, “I need you to quit claim the property back to your name so we can give you the best rates.” As soon as you quit claim the property back to your name, you just created a taxable event. You’ll have a huge tax bill, even though you didn’t sell the property. By holding title in an LLC that is Disregarded for tax purpose, or an LLC taxed as a partnership, there is no taxable event. We can deed the property back to your name, or you and your partners’ names, and there is no taxable event. Keep in mind, there’s no taxable event in most states. However, if you’re property is in Pennsylvania, there will most likely be a transfer tax.
Being armed with this knowledge will help you make wise decisions for you and your family.
