Why You Don't Want to Invest in Real Estate Through an S Corporation

Real estate investors sometimes think about using S corporations for real estate investing. And the idea sounds promising. Almost everybody knows that S corporations are popular. And many people even vaguely know S corps deliver some big tax benefits to small businesses.

Sadly, while many people do hold real estate through an S corporation, an S corporation doesn't make sense for a handful of practical reasons:

No Benefit to Using S Corporation

The first reason you shouldn't put real estate inside an S corporation? Simple. S corporations don't deliver special or extra tax benefits to real estate investors.

Income and deductions within an S corporation retain their character as they pass through the S corporation and flow onto the S corporation owner's tax return. Accordingly, an S corporation doesn't let you avoid the passive loss limitation rules (which often trip up real estate investors). And the S corporation doesn't increase the number of tax deductions you get.

Note: If you're concerned about limiting your legal liability, you don't need to use an S corporation. You can use a limited liability company.

Forces an Extra, More Complicated tax return

One thing putting real estate inside an S corporation does do? A real estate investment S corporation automatically forces you to do an extra, more complicated tax return.

Here's why I say this: A real estate investment that you own or that you own through a one-owner limited liability company can report its income and deductions on a single, simple schedule inside your regular individual income tax return.

Unfortunately, if you own the exact same investment inside an S corporation, you'll need to file a full-blown S corporation tax return. Due by March 15th of each year, the 1120S S corporation tax return will probably cost you several hundred dollars (at least) each and every year.

May Trigger More Complicated Accounting

You what else happens when you put real estate inside an S corporation? You will, as a practical matter, need to step up to a real double-entry bookkeeping system like Microsoft's Office Accounting program or Intuit's QuickBooks program. Why? Because when you do your S corporation tax return, you'll need to include not just statements of income and deductions in your return. You'll also need to include balance sheets at the start and at the end of the year.

Checkbook programs like Quicken will produce statements of income and deductions. No problem. But you'll probably need to buy, learn and then use a full-fledged small business accounting system to produce good balance sheets if you're doing your real estate investing inside an S corporation.

Note: Technically speaking, an S corporation doesn't need to include balance sheets with its corporate income tax return until the corporation's assets exceed $250,000. In some areas of the country, accordingly, a small real estate investor might be able to own one or more properties and not tip over this threshold. In many parts of the country, however, a single property will cost more than $250,000 and, therefore, will mean balance sheets are required if the investment is stored inside an S corporation.

Limits Your Depreciation Write-offs

A real estate investment S corporation will also often limit your depreciation write-offs. The S corporation tax accounting rules that create this limitation are complicated to describe. But in a nutshell, when individuals and partnerships borrow money to purchase the real estate, they may be able claim tax write-offs for depreciation on the owner tax returns.

Note: There are rules which limit these so-called passive losses. But if you can trick your way around the passive loss limitation rules--and maybe people can--you can use the depreciation as a tax deduction on your personal return.

So here's the problem with an S corporation: You can't get tax deductions for things the S corporation borrows money for. If the S corporation purchases the real estate using a mortgage, for example, the S corporation's shareholders probably won't be able claim the depreciation loss.

The reason for this is that you don't get credit (or what tax laws call "basis") for loans other people make to the S corporation. You only get credit (basis) for money you invest in the S corporation or money you lend. And you need basis to claim the deduction.

Note: S corporations and their shareholders can use back-to-back loans to get basis. With a back-to-back loan, the mortgage company loans money to the shareholder and the shareholder then re-loans the money to the S corporation. Then the S corporation buys the real estate with the "mortgage" from the shareholder. This approach, which often works with non-real estate loans, usually doesn't work with mortgages. The bank wants to have a first-row security interest in the property.