Clients often ask CPAs about the best entity structure for holding real estate. The typical response? “A Limited Liability Company (LLC).” Sometimes clients follow up with, “Why not an S Corporation (S-Corp)?” Mainly, if they’ve used an S-Corp successfully for another business, and were comfortable with the tax benefits. Let’s examine the reasons why the landscape has shifted, making LLCs the preferred choice for CPAs.
S-Corps & Real Estate Ownership
It is not unusual for S-Corps to own real estate. By way of example, one of my oldest clients has over $100 million in real estate within an S-Corp. There is a bit of history behind why this happened and why it is not as prevalent today. In 1988, the IRS issued Revenue Ruling 88-76, which provided tax guidance that allowed LLCs to be taxed as partnerships, rather than corporations. Over the next decade, all the states adopted their own LLC laws, allowing LLCs to become an entity structure that many businesses could utilize.
Why Some Clients Used S-Corps Before LLCs
Let’s revisit the S-Corp. Client example – that client formed his business before 1988, so LLCs were not available. Since he was the only owner, he was not interested in going through the steps to create a Limited Partnership.
The Advantage of LLCs for Real Estate Holdings
So, what is the significant advantage of using an LLC to hold real estate? The Debt Basis Rules. With an S-Corp., a shareholder’s debt basis is limited to their stock basis, plus any direct loans they have made to the entity. An LLC not only gets to include the same two items, but it also gets to include two additional items:
- Qualified nonrecourse debt the entity has, AND
- Any personal guarantees the LLC member has made.
How LLC Debt Basis Enhances Tax Benefits
As you can imagine, the addition of these two items significantly increases the LLC member’s debt basis, thereby enhancing their ability to deduct losses from the real estate investment.
The following chart compares LLCs and S-Corps, highlighting why the former is a better entity for holding real estate.
| ISSUE | LIMITED LIABILITY COMPANY | S CORPORATION |
FORMING THE ENTITY
|
Unlimited number of members with very little restriction to the type of owners or membership level
Contribution of appreciated real estate does not need to be a taxable event to the contributing member |
Limited to 100 US shareholders, no foreign ownership, partnerships or corporations, and only one class of stock is allowed
Contributions of appreciated real estate generate taxable income to the contributing shareholder who owns less than 80% of the stock |
| SHARING OF INCOME OR LOSS |
| Based on stock ownership percentages |
| DEBT BASIS TO ALLOW LOSS DEDUCTIONS | Basis Includes:
| Basis Includes:
|
| TAXATION OF CERTAIN TYPES OF DISTRIBUTIONS | Usually not a taxable event to the member receiving the distribution | A taxable event to the shareholder receiving the distribution |
| STEP UP IN ASSETS UPON DEATH |
|
|
So, let’s revisit my client example discussed above, who holds all their real estate in an S Corporation. The business is now over 40 years old, and the property has appreciated. However, the S Corporation structure has become “cumbersome” for the owner as they go through estate planning steps. There are over 30 properties in the Corporation. The owner cannot distribute any property to himself to give to his children without paying income taxes on the appreciation. If the owner wishes to gift any stock to their children, all 30-plus properties must be valued before the stock can be valued (and possibly discounted). The cost to perform that stock valuation is expensive, and would need to be redone every time a gift of stock is made. If the owner holds onto the stock until their death, there is no real estate property-specific step-up in basis to pass to their beneficiaries. As my wife’s grandfather used to say, “You spend half your life collecting assets, and the other half of your life defending those assets.” Currently, the above taxpayer is attempting to determine how to protect their real estate assets from income and estate taxes.
Evolving Entity Structures & the Role of CPAs
Ultimately, while S Corporations were once a common choice for holding real estate, especially before the 1988 change discussed above, the landscape has shifted significantly. Today, LLCs offer greater flexibility, more favorable debt basis rules, and improved estate planning advantages. Transitioning from a legacy S-Corp. The structure of an LLC can be complex and expensive, but proactive planning can help minimize tax exposure. Entity choice plays a critical role in that planning, and CPAs can help guide clients with historical context and future insights.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax or legal advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.