Lately, with all of the buzz about potential tax changes that Congress and the White House have proposed, I have been getting a lot of questions from investors about entity structuring. Everyone wants to know if C Corporations will suddenly become the best entity structure for saving on taxes if the tax law lowers corporate tax rates. Although a potentially lowered tax rate does sound enticing, there are a few other reasons why C Corporations still may not be the best idea for investors. Let’s take a look at some of the details.
The most notorious criticism of C Corporations is double taxation. This is because C Corporations have their own tax rate, and taxes on net income earned in the business are paid by the corporation with corporation funds. In addition, if any money is taken out of the corporation by the investor, then they have to pay tax on that money as well on their personal returns with personal funds. Essentially, those funds are being taxed twice: once at the entity level when they are earned and again at the personal level when they are distributed as either dividends or payroll.
This is one of the reasons that pass-through entities are often viewed as better tax entities for investors. Instead of paying a corporate tax rate and then a personal tax rate, all of the earnings within the pass-through entity flow through to the personal tax returns where the taxes are paid. Subsequent dividends or distributions are not taxed separately again. They are essentially a tax-free transfer of funds.
Preferential Tax Rates on Capital Gains
One of the great perks of real estate investing is capital gains rates on the sale of real estate. Generally, if you are an investor selling a long-term rental property, you can use a lower capital gains rate instead of being taxed at your usual marginal tax rate. Currently, if you are in the 10 to 15% bracket, then your capital gains rate is zero. Meanwhile, if you are in the 39.6% bracket, your capital gains rate is 20%. Anything in between those brackets is 15% long-term capital gains tax rate.
When you invest with a pass through entity such as a partnership or even an S Corp, you get to utilize these capital gains rates and pay less in tax on the sale of rental real estate. On the flip side, in a C Corp, there are no capital gains rates. Currently, the corporate’s highest tax rate is 35%, and ordinary income and capital gains are both subject to that tax rate. In addition, if you have dividends from the C Corporation (the equivalent of distributions from a partnership or S Corp), they are taxed at your tax rate, regardless of the type of income being distributed. For example, if you sold a rental property that was held by a flow-through entity such as an LLC, Partnership, or S Corporation, you may be able to pay lower capital gains taxes of 15%. Alternatively if this same rental was sold in a C Corporation, then the tax rate can be as high as 35% inside the Corporation with an additional tax on the dividends when you later take those funds out of the Corporation. That can be a double whammy for many investors.
One of the major perks of investing in rental real estate for many investors are tax losses on rental properties. If you have rental deductions in excess of your rental income, you can oftentimes use it to offset W-2 and other income if you meet certain criteria. One such criteria is if you make under $150k during the year, then you are able to take up to $25k of excess rental losses. If your income is over $150k, then you may need to qualify as a real estate professional in order to offset W-2 earnings with rental losses. This tactic works whether you personally own your rentals or own them via a flow-through entity. However, if you have a C Corporation, you aren’t able to use losses to offset your W-2 income. The reason for this is because a C Corporation is a separate taxing entity from you. As such, any deductions, expenses, or losses generated in the corporation are trapped inside that corporation and do not flow through to your personal tax return to lower personal taxes.
For example, let’s say you have $50k of W-2 wages and $10k rental losses from a partnership. The losses would offset your income and leave you with $40k of total income. Any distributions that you take out of the partnership subsequently would not be taxed again. Then you subtract your itemized deductions and exemptions, and whatever is left over would be taxed at your personal marginal tax rate. If instead the rentals are held in a C Corp, the C Corp would have a $10k loss for the year, resulting in zero taxes at the corporate level. However, you would still separately pay taxes on the $50k of W-2 wages. The result is that you would pay taxes on $10k more because of the fact that your rental losses would now be trapped inside of your C Corporation.
Issues With Property Transfers
This last downside applies to both C Corporations and S Corporations and is the main reason why we suggest using partnerships, LLCs, and disregarded entities for real estate. Oftentimes, if you wish to refinance a rental property, the lender requires you to hold title in your personal name, outside of the entity. If you have a partnership or LLC, it is as easy as quit claiming the property from your LLC to yourself, and there are no tax issues, generally speaking.
In a C or S Corporation, the act of transferring title from the corporation to your personal name is treated as if you sold the rental to yourself for the current fair market value of the property. This is oftentimes referred to as a “deemed sale,” which simply means that the IRS treats the transaction like a sale even though you have not actually sold the property. This can create some tax issues if the underlying property has increased in value.
Let’s go over an example. Assume you have a rental property that was purchased for $100k with a fair market value of $150k when your lender indicates the property must be moved to a personal name in order to refinance. By simply transferring title of this property from your C Corporation to your personal name, there is a deemed sale resulting in gain of $50k. Remember earlier we mentioned there are no capital gains for C Corporations? This $50k is ordinary income that the C Corporation needs to pay. It can be extremely detrimental to pay taxes on something you have not yet sold where you have simply moved title from your corporation to your personal name.
The IRS code is filled with confusing and potentially hazardous pitfalls. Therefore, regardless of the current or future corporate tax rate, there are still a lot of downsides that can make a C Corp less than ideal for rental real estate. This is why it is important to consider all aspects of entity formation before choosing an avenue. You may be surprised to realize that you may not even need an entity to maximize your tax savings. Depending on the amount and value of your investments, insurance may be all you need to protect yourself. When it comes to entities, not all structures are created equal, so make sure that you work with your advisors ahead of time before you spend the time and money to form an entity that may not be beneficial to you.
Investors: What are your thoughts on these proposed changes?
Be sure to weigh in below!