9 Reasons it's Dangerous to Hold Real Estate In a Corporation

Holding investment real estate in a corporation is tempting because of the liability protection. Unfortunately, it can be a terrible tax decision causing you to lose most of the income gained from the investment (and possibly even more).

Here are 9 reasons to reconsider holding investment real estate in a corporation:

#1 No capital gains rate

Although you may be investing for the sake of cash flow, you’re likely to sell at some point and usually at a gain, since real estate tends to appreciate. Unfortunately, C-Corporations don’t have access to the 15% capital gains tax rate. Any gains would be taxed at the flat 21% corporate tax rate.

#2 Double taxation

As with any other business income, C-Corporations are treated differently when it comes to property sales. If you sell appreciated property, the shareholders will pay taxes on the dividends and the corporation will pay taxes on the income as well. As stated above, the corporation's tax will be at the regular rate, not the lower capital gains rate.

If the corporation distributes property directly to shareholders, Section 311(b) of the IRC deems this the same as a sale and triggers double taxation of any appreciated value in the property just as if it had been sold for cash.

#3 Rental losses

With most tax structures, rental losses can be deducted. However, for real estate owned by a C-Corp, the loss must be kept inside the corporation. What does that mean? It can be carried back to reclaim taxes paid in the past two years, or carried forward to offset future corporate income taxes. However, it offers no current tax benefit on a shareholder level.

#4 1031 exchanges are complicated

1031 exchanges can be a great tool for deferring capital gains tax, but with a corporation it gets more complicated. In order for a C-Corporation to make a 1031 election, all shareholders need to approve. If you have multiple shareholders and can’t get everyone to agree, you may lose the ability to use this helpful tax strategy.

#5 Hard-to-sell stock

Selling your company can also become more difficult if you hold investment real estate in a C-Corp. One of the benefits of a corporation is the ease of selling stock to raise money or distribute ownership to more people. Unlike a standard real estate purchase, buyers of the stock will not receive a step-up basis in the real estate. They’ll be in a bad spot in terms of basis when that property is sold. Ultimately, most buyers won’t be interested in purchasing stock in a C-Corp holding appreciated real estate.

#6 No step-up basis for beneficiaries

The basis problems don’t end with selling shares. If you hold real estate in a C-Corp at the time of your death, your heirs will have basis issues as well. Typically, they would inherit the property with a step-up basis at its fair market value. This protects them from excessive gains taxes when they sell. But, like the stockholders, if they inherit real estate held in a C-Corp they miss out on that step-up basis. Their basis will be based on historical value and they’ll be hit with a big capital gains tax if they sell the property.

#7 No debt basis in loans

Don’t worry, basis issues haven’t forgotten about S-Corporations. When an S-Corp receives a loan from a third party, shareholders receive no debt basis. Why is that a problem? Because debt basis and stock basis are used to determine taxes on distributions and the deductibility of losses. Shareholders without sufficient basis are at a huge disadvantage. This seriously decreases the tax benefits of owning real estate in an S-Corp and makes it very hard to attract investors.

#8 Refinancing

Need to refinance a property? If it’s owned by a C-Corp you’ll create a taxable event. Any proceeds from cashing out during a refinance will be non-deductible to the corporation and taxable to the shareholders as well.

#9 BIG tax problems

C-Corporations take a big tax hit when they sell appreciated stock, even if they’ve elected S-Corp status. The Built-In Gains (BIG) tax requires capital gains to be taxed at the regular corporate tax rate for previously held assets sold within ten years of making the S election.

The solution

The best way to hold investment real estate will depend on the situation. In most cases, a limited liability company, limited partnership, or real estate investment trust are the best options, depending on the number of properties and investors involved.