Some accountants like to say there’s an eleventh commandment, “Thou shall not hold real estate inside a corporation.” And, in general, this rule holds true. Inside a corporation, real estate loses many of its tax benefits.
In a handful of cases, however, a special sort of corporation– a subchapter S corporation–may be useful for real estate investors, as discussed below…
S Corporations Work Well for Real Estate Flippers
One situation where an S corporation works well is flipping.
If someone regularly flips real estate, profits and losses are not treated as capital gains or capital losses. Rather, profits and losses are treated as ordinary income and loss.
That “ordinary” treatment isn’t all bad. For example, while ordinary income never gets taxed using the low capital gains rates (which is bad), an ordinary loss unlike a capital loss can easily be used to offset other income (which is good).
However, “ordinary” treatment creates a trap for real estate flippers. Ordinary income is subject not just to income taxes–but also to self-employment taxes. Specifically, in addition to any income taxes a real estate flipper pays on his or her profits, a flipper also pays a 15.3% self-employment tax on roughly the first $100,000 of annual profit and a 2.9% self-employment tax on anything over $100,000 in annual profit.
For example, a house flipper that makes $100,000 in some year pays not only income taxes but also a 15.3% self-employment tax, or roughly $15,000.
An S corporation, however, offers up a loophole. In an S corporation, only that portion of the profit that gets paid out as designated wages gets subjected to the employment tax.
Suppose, for example, a real estate flipper operates as an S corporation, makes $100,000 in profit some year, but pays only $50,000 of this profit out to the shareholder-employee as wages. In this case, the employment tax equals 15.3% of the $50,000 of wages, or roughly $7500. And the S corporation therefore saves the real estate investor about $7500.
S Corporations Work Well for Rehabbers
And there’s a related group of real estate investors for whom an S corporation works, too.
If you’re someone who’s buying fixers, making substantial improvements, and then re-selling, there’s a good chance that your real estate activities are considered an active trade or business (which means ordinary income treatment and self-employment taxes).
Accordingly, rehabbers may be able to use an S corporation to save on employment taxes, too, just like flippers do.
A quick digression: If you’re confused about how real estate flipping or rehabbing can be treated as an active trade or business and subject to both ordinary income and self-employment taxes, think about the cases of a retailer or a home builder. A retailer selling, for example, furniture does not get to call his profit capital gain. And a home builder constructing spec homes does not get to call his profit capital gain.
From the point of the tax laws, a flipper is just a “retailer” whose inventory consists of houses. And a rehabber is sort of a home builder.
S Corporations For Property Management Activities
One other S corporation opportunity exists for real estate investors. Specifically, passive real estate investors may sometimes benefit by setting up an S corporation to perform property management for their real estate. This S corporation then employs the real estate investor to do the work of managing, the properties.
A property management S corporation sometimes makes sense because the S corporation allows the real estate investor to accrue social security benefits and because the S corporation, by creating earned income for the real estate investor, also lets the investor provide him- or herself with tax-free fringe benefits like a retirement plan or health insurance.
A real estate investor with, for example, half a dozen rental properties might be able to setup a property management S corporation, pay a modest but fair salary, and then provide tax-free health insurance and a 401(k) to his or her family. These sorts of tax-free fringe benefits could save a family $5,000 to $10,000 a year in taxes.
Note: Setting up an S corporation for property management purposes can be tricky. While real estate investors tend to be a do-it-yourself bunch, for an S corporation, you probably want to get expert help from a knowledgeable CPA, tax attorney or enrolled agent.