Why Long-Term Rentals Should Never be Held in an S-Corp or LLC taxed as an S-Corp

“Risk comes from not knowing what you’re doing.”  This is a quote from Warren Buffet, and I think of it many times a week.  It crossed my mind just the other day when I had a new client call me to review her Legal Structure and see if there are any tips I could give her to improve it.  Right away, I noticed that she was holding some rental properties in her LLC that is taxed as an S-Corp (LLC-S).  This is the same LLC that she does her property flips in.  There are plenty of investors who ask if they should hold their rentals in an LLC-S.  Sadly, there are many investors who don’t ever ask and just do it.  They just go with what they have.  Here are a few things to consider when running an active Real Estate Business in an LLC-S and thinking you may just hold your rental in that same entity. 

The number one thing to know is that when you hold rental property in the same LLC in which you are doing Flips/Wholesales in, you are doing something called cross-contamination of liability.  What you are doing is running two businesses inside of the same entity.  If there was a lawsuit against one of your rentals, then the flips you are working on will share in that liability.  Conversely, if you have a legal issue with one of your flips, the rental properties will share in that liability.  This is something we want to always avoid.

Another reason why you would not want to place rentals in an LLC-S is the possibility of having your S-Election revoked by the IRS.  This one is not very well known and catches many investors off guard.  There is something out there called Termination of Election.  This happens when an S-Elected LLC has rental properties in it and generates more than 25% of its profits from Passive Investment Income.  The term “Passive Investment Income” means gross receipts derived from royalties, RENTS, dividends, interest, and annuities.  Once this happens, your S-Election can be revoked by the IRS under Section 1362(d)(3)(A), and they can make you pay capital gains on the liquidating assets. 

This brings me to the third reason why rental income in an LLC-S is not good. The triggering of a Taxable Event.  Let’s say you sell the rental property.  In an S-Elected structure, the gain from the sale is passed through to the shareholders, who must report it on their personal tax returns. This can result in a significant tax liability, especially if the property has appreciated considerably in value.  Distributing real estate or other assets from a Disregarded LLC (Rental Structure) typically doesn’t result in the same tax consequences as distributions from an S-Elected LLC. This makes it easier to move assets in and out of the LLC without incurring prohibitive tax liabilities. What if you were to transfer a rental property out of your LLC-S?  Keep in mind that when real estate is distributed from an LLC-S to its shareholders, the IRS often treats this transaction as a deemed sale, meaning the corporation is considered to have sold the property at its fair market value, which can result in a capital gain.

Finally, there is the step-up in Cost Basis.  When you purchase a rental property, the price you pay is known as the Cost Basis.  When the property is sold, you get taxed on the difference between the Cost Basis and the Market Value you sold it for.  Since you transferred or held your property in an S-Elected entity, you lose the step-up in cost basis at death. Corporations don’t die, so there’s no step-up in basis. In other words, your heirs inherit the corporation’s stock rather than the property itself. This means they inherit your original cost basis and potentially face a hefty tax bill when they eventually sell the property.

The best way to hold your Rental Properties is in a Passive Structure that utilizes a disregarded LLC and Land Trusts.  Doing this will provide you with many benefits.  This structure offers more straightforward methods for distributing profits and assets to its members without triggering significant tax events. LLCs can distribute profits in a manner that suits the business’s needs and the members’ agreements without the rigid requirements of an S-Elected Entity. It also offers estate planning benefits that aren’t available to S-Elected Entities. Members can transfer their ownership interests through gifting or inheritance without triggering tax events. This can simplify estate planning and ensure the smooth transition of assets to heirs. 

Let me know if you would like to receive a Passive Structure Flow Chart to get a better idea of what it looks like. You will see how it will make your Rental Structure more efficient, scalable, and manageable.  All the best qualities of a successful business.

With NCH, the state’s top business formation service, you can register your LLC in Nevada quickly and easily. Our specialists will help you choose the right entity for your company and understand why an LLC in Nevada is your best option. We’ll assist you with all necessary Nevada LLC forms, including the vital Articles of Organization, and help you comply with state regulations. In addition, we offer expert assistance with tax compliance, credit building, and payroll management. Schedule a private consultation to explore effective solutions to minimize tax liabilities and protect your wealth. Start unleashing your LLC’s full potential today with NCH. Schedule a consultation with Carlos Espinel today!

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.