What if you die and your S Corp owns rental property?

Owning rental property through an S Corporation (S Corp) can offer various tax advantages and liability protection during your lifetime. However, the situation becomes more complicated when the owner of an S Corp passes away. Estate planning and the subsequent management of rental properties owned by an S Corp require careful consideration. This article explores what happens to rental properties held in an S Corp upon the owner’s death, the potential benefits and drawbacks of this arrangement, and whether it’s advisable to use an S Corp for real estate holdings.

What is an S Corporation?

An S Corporation (S Corp) is a type of business structure that allows income, losses, deductions, and credits to pass through to shareholders for federal tax purposes. This means that the corporation itself does not pay income tax; instead, the corporation’s income or losses are reported on the shareholders’ personal tax returns. This pass-through taxation can be beneficial, especially for small business owners, as it avoids the double taxation that occurs with C Corporations.

However, while S Corps offer several benefits for active businesses, using them to hold rental real estate is often discouraged due to specific tax and legal implications, particularly when it comes to estate planning.

What Happens to the S Corp if the Owner Dies?

When an owner of an S Corp dies, the shares of the corporation become part of the owner’s estate. What happens next depends on several factors, including the corporation’s governing documents (like bylaws or a shareholders’ agreement), state laws, and the deceased’s estate plan.

Transfer of Shares

The deceased owner’s shares in the S Corp can be transferred to heirs or beneficiaries as outlined in their will or trust. The transfer of shares can continue the corporation’s existence, but there are important considerations:

• Eligible Shareholders: S Corps have strict rules about who can be a shareholder. Only certain entities and individuals can own shares in an S Corp. For instance, non-resident aliens and most types of trusts are not allowed to be shareholders. If the shares are transferred to an ineligible entity, the S Corp could lose its S Corporation status and be taxed as a C Corporation, leading to significant tax implications.
• Step-Up in Basis: Unlike property held directly by an individual, shares of an S Corp do not automatically receive a step-up in basis upon the owner’s death. A step-up in basis adjusts the value of an asset for tax purposes to its current market value at the time of inheritance, reducing potential capital gains tax when the asset is sold. Without this step-up, the heirs may face a larger tax burden when selling the property.
• Continuity of Operations: The S Corp itself can continue to operate after the owner’s death, but this requires that the heirs or new owners actively manage the corporation, comply with all corporate formalities, and continue to meet the S Corp eligibility requirements.

Should I Put My Rental Property into an S Corp?

Deciding whether to place rental property into an S Corp requires careful consideration of several factors:

Pros:

• Liability Protection: An S Corp can provide liability protection by separating personal assets from the business’s liabilities. If the S Corp is sued, the owner’s personal assets are generally protected.
• Pass-Through Taxation: Income from the rental property passes through the S Corp to the shareholders, who report it on their personal tax returns, avoiding double taxation.

Cons:

• No Step-Up in Basis: As mentioned earlier, property held in an S Corp does not receive a step-up in basis upon the owner’s death, potentially leading to higher capital gains taxes for heirs.
• Complexity: Managing an S Corp involves adhering to strict IRS rules, maintaining corporate formalities, and potentially facing additional administrative and legal costs. For rental properties, this complexity is often unnecessary compared to simpler structures like LLCs.
• Limited Deductions: Unlike real estate held directly or through an LLC, an S Corp has restrictions on the types of expenses that can be deducted, which may limit tax benefits.

Why Is It Bad to Put Real Estate in an S Corp?

Real estate is typically not suited for ownership within an S Corp for several reasons:

• Difficulty with Transferring Property: Transferring property in and out of an S Corp can trigger significant tax consequences. When property is transferred into an S Corp, it may be considered a sale, potentially resulting in taxable gains. Similarly, transferring property out of an S Corp can lead to gain recognition for the corporation.
• No Step-Up in Basis: As discussed, the inability to receive a step-up in basis at death is a significant drawback of holding real estate in an S Corp.
• Distribution Limitations: Distributions of appreciated property from an S Corp to shareholders can also result in taxable events, unlike with an LLC where distributions can often be made tax-free.

Is It Better to Hold Real Estate in an LLC or S Corp?

For most real estate investors, holding property in an LLC (Limited Liability Company) is generally more advantageous than an S Corp. Here’s why:

• Liability Protection: Like an S Corp, an LLC offers liability protection, shielding personal assets from business liabilities.
• Step-Up in Basis: Real estate held in an LLC that is owned by an individual or a revocable trust typically receives a step-up in basis upon the owner’s death, reducing capital gains taxes for heirs.
• Flexibility: LLCs offer greater flexibility in terms of management, ownership structure, and the ability to distribute profits without triggering unnecessary taxes.
• Fewer Restrictions: LLCs have fewer ownership and operational restrictions compared to S Corps, making them easier to manage.

What Happens to Rental Property if the S Corp Owner Dies?

If the owner of an S Corp that holds rental property dies, the corporation continues to exist, and the rental property remains owned by the S Corp. However, the fate of the rental property depends on the transfer of the deceased owner’s shares:

• Heir’s Role: The heirs or beneficiaries who receive the S Corp shares must continue to manage the corporation and the property. They must also ensure the S Corp remains in compliance with all IRS rules.
• Tax Implications: Heirs inherit the S Corp shares at their current value, but the underlying rental property does not receive a step-up in basis. This means that if the property is sold, the capital gains tax will be based on the original purchase price, not the value at the time of the owner’s death.
• Business Continuity: The business can continue to operate as before, but it’s crucial that the heirs understand the responsibilities and tax implications associated with managing an S Corp.

Conclusion: Navigating the Complexities of S Corps and Real Estate

While S Corps can be beneficial for certain types of businesses, they are often not the best vehicle for holding rental real estate, particularly when considering estate planning and the potential tax implications upon the owner’s death. The lack of a step-up in basis, the complexity of transferring property, and the ongoing administrative requirements make S Corps less desirable for real estate investments compared to LLCs.

If you currently hold rental property in an S Corp or are considering this structure, it’s essential to consult with a tax professional or estate planner who can help you navigate these complexities. At Molen & Associates, we’re here to guide you through the intricacies of real estate ownership and estate planning, ensuring that you make informed decisions that align with your financial goals.

Contact us today to discuss your real estate holdings and explore the best strategies for protecting your assets and minimizing tax liabilities.