S Corporations can be a great entity to have if you are in the business of flipping properties, running a professional practice, or doing construction. They provide great asset protection and may help you minimize self-employment tax that you would normally have with an LLC. An S Corporation also helps you to avoid the double taxation that you may have with a C Corporation. However, if you own rental real estate, then you may want to consider forming a different entity. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free Here’s why. The Issues with Transferring Appreciated Real Estate Holding real estate in an S Corp does not pose a problem while it is held. You can collect rent, pay expenses, and put the property in the name of the S Corporation. Business is run as usual, and asset protection is in effect if you operate the corporation property. The issues arise when it’s time to get the property out of the entity. Now, you might be thinking, “Why would I want to transfer property out of an S Corp?” There are many reasons why an investor may want to get properties out of an S Corporation. One of the most common ones we see is with respect to financing. Some banks will lend money to an S Corp, and other lenders will only allow you to finance or refinance if the title is in your personal name. Another common reason we see investors transfer title of a property from their S Corporation into their personal name is when they turn the rental into their primary home. Related: 3 Tell-Tale Signs You’re NOT Running a Tax-Efficient Business A Real Life Example Last year a family friend of mine, Tracy, decided that she wanted to sell one of her rental properties. She had purchased the single family home for $150,000 several years ago, and the fair market value of the property was now close to $300,000. Tracy was excited to learn that her property appreciated so much, but she was dreading the capital gains taxes that she may have to pay. After speaking with her tax advisor, Tracy learned that she could potentially exclude the gain on the sale of this property if she lived in the home for two of the five years prior to selling the home, so she decided that she would turn this property into her primary home. That way, she could potentially create more appreciation in the next few years with this property and possibly pay zero tax on the gain of this investment. This all sounded like a wonderful plan until she found out there was a catch to her brilliant idea. The catch was that this investment property was currently held in her S Corporation. By transferring the property out of the S Corp, the IRS treats this transaction as a “sale.” In the eyes of the IRS, Tracy was essentially selling the property to herself for the property’s fair market value of $300,000, triggering a $150,000 gain that she would have to pay tax on that year. Can you imagine paying taxes on a $300,000 taxable gain when the property was not sold and title was merely transferred from your S Corporation to your personal name? As you can see, this was a potentially huge problem for Tracy. She would need to be able to come up with the cash to pay taxes on this “sale” of the property when no actual sale had occurred. This is one of the pitfalls of having rental properties in an S Corporation that investors are often unaware of. Also, keep in mind that if Tracy’s S Corp had other owners besides herself, then the other shareholders would not have been very happy with her when she transferred that property, as they would have also been required pay tax on that gain in proportion to their share of the S Corporation. If, for instance, there are five shareholders and each owned 20% of the corporation, then each of them would need to pay tax on $30,000 of the gain. The small amount of good news is that in the future when it was time to really sell the home, Tracy’s basis in the property would be $300,000, not $150,000. If the house rose in value over the next few years, then she could exclude some of the additional gain when it came time to sell, but as far as excluding the $150,000 that year, Tracy’s strategy would fail miserably. Whether you are moving a property out of an S Corporation for loan purposes or to turn it into your primary home, be sure to plan with your tax advisors strategically prior to making this move. Transferring Depreciated Real Estate May Not be Beneficial Either Although you can avoid paying tax by transferring property that has depreciated in value, there isn’t a benefit to doing this either. Most would think that if you recognize a gain when fair market value is higher than the purchase, then you would recognize a loss if the fair market value is lower. Generally, this is the case, but not when it comes to transferring property out of an S Corp. The loss essentially disappears, as the S Corp cannot recognize it. So even though you avoid paying tax, you also miss out on deductions. Even if your property has gone down in value, you may still trigger a gain. The gain on the distribution is calculated by taking the fair market value minus your adjusted basis. Adjusted basis is your purchase price minus any depreciation you have taken on the property. So if you purchase a property for $100,000 and take $5,000 of depreciation each year for five years, then your adjusted basis is actually $75,000. If the fair market value falls to $90,000, even though it is lower than your purchase price, it is higher than your adjusted basis, and you may have to pay tax on a $15,000 gain. Again, please make sure to speak with your tax advisor before moving properties in or out of your legal entities. Related: The Ultimate Guide to Real Estate Investment Tax Benefits Why LLCs May Be a Better Option If Tracy had held her rental property in an LLC, then her gain exclusion strategy could have potentially worked. If she had transferred her $150,000 property out of an LLC, then there would have been no gain since it is not deemed as a sale. It’s simply treated as a distribution. She would have kept the $150,000 basis, and if she lived in the house for two years, then she have may potentially excluded the $150,000 gain when she sold the property. Holding rentals in an LLC creates much more flexibility if you need to move rentals to a new LLC, convert one to a primary home, or transfer to your personal name to refinance. For example, if your business does both fix and flips and rentals, you may want to consider separating the two businesses. Hold your fix and flip properties in an S Corp, and keep your rentals in LLCs. Before you go out to form that new entity, do make sure to speak with your tax advisor because there are always exceptions to the rule. Make sure that you have the best type of entity for your real estate business. Oh, and don’t forget to get your book today on Tax Saving Strategies for the Savvy Real Estate Investor. It just may be a tax deduction that can save you tons of money! [Editor’s Note: We are republishing this article to help out our newer readers.] Investors: Have any questions about legal entities and rental properties? Leave your comments below!