There is one tax rule that applies almost universally in the real estate industry:
Never put real estate into a corporation (including S-corporations).
Why not? Once you put an appreciating asset into a corporation, you cannot take it out without triggering capital gains tax. You’re locked in. Although S-corporations are flow-through entities just like partnerships, they are still classified as corporations under the tax code. For that reason, once appreciating real estate is moved into an S-corporation, it cannot be taken back out without triggering capital gains tax on the built-in appreciation. (See IRC § 311)
To drive the point home, imagine that you bought a rental property worth $100,000 5 years ago and put it into an S-corporation. The property appreciated to a value of $200,000 over the next 5 years. In tax terms, you have $100,000 of “built-in capital gain.” At this point, there are a host of different reasons why you might want to move the property out of the S-corporation. Maybe your lender requires that you own the property in your personal name in order to use it as collateral. Maybe you own the S-corporation with your kids or family members and you want to transfer the property to one of them.
If you take the property out of the S-corporation for any reason, you will trigger taxes on the built-in capital gain of $100,000. At current rates, that’s a tax bill of $15,000. That tax bill could have been deferred if the property had been held in a partnership (or an LLC taxed as a partnership.)
But why is it so important to defer capital gains tax? You have to pay it at some point anyway, right?
Deferring taxes is much more than a matter of timing. When you defer taxes, you keep money in your pocket for longer, thereby leveraging the time value of money. This is a basic tax concept and one of the primary advantages of real estate as opposed to other investment vehicles. For every dollar of tax you defer, you have one more dollar to leverage in your real estate business, which increases your earnings potential.
Furthermore, if you defer capital gains taxes for long enough (possibly until your death), you may avoid paying them completely. When you die and leave real estate to your beneficiaries, they generally receive those assets free of capital gains liability. In tax language, your beneficiaries receive a “stepped-up basis” in real estate. This simply means that they never have to pay the capital gains that you would have paid if you had sold the real estate during your lifetime.
If you are absolutely certain that you will never need to take your real estate back out of your S-corporation (or if you just love paying capital gains tax) then there would be no real problem with using an S-corporation. However, the situations where this makes sense are few and far between. This is why nearly all tax practitioners strongly discourage putting real estate into an S-corporation.