LLC Vs. C Corp Vs. S Corp Tax Advantages for Real Estate
Many real estate investors move away from a sole proprietorship to own property and register as a business, for both liability and tax advantages. Establishing a limited liability company (LLC) or a corporation protects real estate assets from liabilities such as lawsuits and credit issues. However, there are tax pros and cons with each type of business entity. Most real estate investors prefer the LLC for tax purposes when compared to the C-corporation or the S-corporation.
Moving Away From Sole Proprietorship
Sole proprietors operate a business under their individual Social Security Number. Being sole proprietor means you are the business entity responsible for all liabilities and taking in all income; there is no separation between your finances and the real estate business. This is the least protective business entity but it does offer a key tax advantage for real estate owners.
The key tax advantage is the Internal Revenue Service capital gains exclusion: if a sole proprietor has lived in a home for two of the previous five years prior to selling, there is a $250,000 ($500,000 for married couples filing jointly) capital gain exclusion. Additionally, as long as the property is passively owned, such as a rental property and not a flip, there is no self-employment tax imposed. Despite the tax advantages, most real estate investors’ concerns about liability become the impetus for establishing a separate business entity.
The LLC Real Estate Advantage
An LLC is a legal entity registered with the secretary of state. As the name suggests, this entity limits liabilities such as injury on a property or a foreclosure of the real estate to the LLC. The owner's other personal assets are not risked. For tax purposes, the LLC passes through all income and expenses to the LLC owner's personal tax return. Even though the LLC provides liability protection, it is not considered a separate tax entity for income.
Even though the income is passed to the LLC owner, so are the expenses, county property taxes and depreciation on the assets and major improvements. Additionally, real estate developers often subdivide a property. In an LLC, subdividing the parcel enables you to distribute part of the entire property without incurring a fully taxable event. Because of the flexibility on how assets come out of the LLC, most real estate investors prefer this structure.
There are two tax disadvantages to an LLC real estate holding company: owners still pay self-employment taxes, and if the property had ever been a personal residence, the IRS capital gain exclusion is forfeited.
Corporations: Liability Benefits Not Taxes
There are two types of corporate entities, the S-corporation and C-corporation. Like the LLC, both corporations separate corporate shareholder assets from corporate assets. This protects shareholders person assets from professional liabilities and vice versa.
Corporations do well to protect against liabilities but real estate that goes into either type of corporation never comes out tax-free. Even subdivided transfers are taxed, based on the appraised transfer of assets. Subdividing simply isn't possible in a corporation with the same tax benefits as the LLC. This is a significant disadvantage for real estate investors.
Differences Between S-Corporation and C-Corporation
The S-corporation allows shareholders to pass the income to personal taxes, whereas the C-corporation files business tax returns, further separating personal and business assets. The S-corporation helps mitigate some of the self-employment taxes, because owners can classify money partly as income and partly as a distribution. The income segment is considered for self-employment taxes, whereas the distribution is treated as ordinary income.
C-corporations provide owners with IRS Form K-1 to record dividend payments from the company; thus, self-employment taxes are entirely avoided. However, the C-corporation model ends up double taxing the profits, once at the corporate tax rate, and then as a dividend distributed to the owners.
References
- FindLaw: LLC Member Tax FAQs
- Intuit: How an S-Corp Can Reduce Your Self-Employment Taxes
- S Corporations Explained: Can I Use an S Corporation For Real Estate Investing?
- Forbes: Tax Geek Tuesday: Why You Should Never Hold Real Estate In A Corporation
- Market Watch: The advantages of owning real estate in a single-member LLC
Writer Bio
With more than 15 years of small business ownership including owning a State Farm agency in Southern California, Kimberlee understands the needs of business owners first hand. When not writing, Kimberlee enjoys chasing waterfalls with her son in Hawaii.