Updated: Jul 24
Holding property inside of a business is not a new concept, but there are things you want to keep in mind if you hold property inside a business (or transfer out of your business), especially if there is a mortgage attached.
Why do people want to hold property inside a business instead of personally holding it?
It provides asset protection against creditors.
It is a way for multiple owners to purchase a piece of property
What entity type is best for holding property?
There are pros and cons of different entities, but typically a partnership (or LLC taxed as a partnership) fares better than an S or C corporation. There are a couple of reasons for this:
Debt basis rules
Taxability of property distribution
Let's take a look at how the above plays out in the three different entities:
Debt basis rules
Let's say Jessie and Dana decide to purchase a rental property, and they want to create an entity to title the property. They will both own 50%. They purchase a $500,000 property, and each put $25,000 down. The remaining $450,000 is covered by a mortgage that the entity takes out.
Let's assume the mortgage is interest-only for the first five years and that the property generates $5,000 net before depreciation and has a loss of $10,000 after depreciation. The business distributes cash flow annually. Since there is a loss and each person owns 50%, there is a basis reduction of $5,000 each per year.
C corp: Losses do not flow to shareholders, so there is no benefit
S corp: Shareholders only get basis for loans made directly to the corporation by the shareholder, even if an external loan is guaranteed by the shareholder. So based on the above example, in year 4, the losses from the business will be suspended, and the shareholder will need to recognize a gain for distributions in excess of basis.
Partnership: A partner gets basis for their share of the debts, including those owned by a 3rd party (the bank in this case). Based on the above example, they will continue to use any losses generated for many more years after the S corp shareholder would.
Taxability of a property distribution
So let's say you want to get the property out of the entity, or one of the owners wants to exit.
Partnership: In most cases (you will need to talk to a professional about your specific situation), property that is distributed from a partnership is not a taxable event. This is because no gain is recognized until the property is sold.
S corp: If a property is distributed from an S corp, it is deemed a sale, and any gain is taxable to the S corp, which flows through to the shareholders. On the bright side, the shareholder who receives the property will have a higher basis in the property going forward, but that comes at the cost of paying for the taxable gain in the year of distribution.
C corp: Similar to an S corp, if a C corp distributes property to a shareholder, it is deemed sold at FMV at the date of distribution. In this case, since it is not a flow-through entity, the shareholder would receive a taxable dividend equal to the FMV of the property.
There are, of course, other factors to consider, like what happens to the property if one of the owners dies, but the above factors make it clear that a partnership is the better option for holding real estate.