S Corporation – For real estate, S corporations have gone slightly out of favour, but not for good reasons. Forming an S corporation to reduce liability and save taxes for real estate is still worth it. Many people would strongly profit from a s corporation for their real estate investments. We discuss here the forms you need, how to file, what the advantages, disadvantages, and risks of S corporations for real estate are, and much much more.
S Corporation: Formation, Advantages and Disadvantages
The S Corporation is typically for short term investors. Its form can typically be found in investors who prefer to flip house, rather than the more longterm investment options such as the limited partnership. It is handy to know that this form exists, and its advantages and disadvantages. Even you may find that this type of company can be quite handy in reducing your liability and increasing profit.
Definition and Basics: S Corporation
S corporations, also shortened to S corp, are corporations. These include a certain amount of shareholders, to whom profits, losses, etc. are passed on to. That means instead of the company being the owner of the profits, it is directly passed through to all shareholders. This typically means less tax on income for everyone.
Can an S Corporation Own Real Estate?
Yes, and in fact, real estate investors who often find themselves selling real estate are most advantaged by an S corporation (or an LLC taxed like an S corporation).
- Best for selling real estate
Forming a S Corporation: How to Change Status
This makes it clear what an S corporation is. The question is now how to become such a corporation. Before starting this process, make sure you qualify, as detailed by the IRS.
Requirements for Becoming an S Corporation – Regulations
According the IRS, to qualify for forming an S Corporation you must first fulfill these requirements:
- Not be an international corporation
- Shareholders must be allowable (can be individuals, certain trusts, and estates but not partnerships, corporations or non-resident alien shareholders
- Fewer or equal to 100 shareholders
- Limited to one class of stock
- Not be a financial institutions, insurance companies, or domestic international sales corporations
Easy Process – All Steps to Becoming an S Corporation
To change the status of your corporation to an S corporation, you just need to fulfill the requirements, and fill in the form 2553 from the IRS. It must then be signed by all shareholders (as well as their spouses potentially). If it is a new corporation,it has two and a half months after inception to file for S corporation status. Otherwise, they will stay in the C subchapter.
- Form 2553 from IRS
- Signed by all members
- Filed in time
- Form 2553 – IRS
Advantages: Installments, Tax Deductions and Depreciation
The seller of a piece of real estate can avoid self-employment/social security tax on a part of the amount which he or she is making thanks to the sale of real estate. Other advantages include the fact that S corporations avoid double-taxation, protect shareholders liability, reduce self-employment taxes and (under certain conditions) allow for contribution of appreciated property to the S corporation without recognizing a gain. As with most real estate entities, an S corporation will also protect shareholders from liabilities.
- Installment sale method of recognizing gains
- Capital gains tax rate
- Tax-free exchange of property
- Depreciation deductions
Disadvantages: Deducting Losses, Limits and Stock Classes
S corporation are controversial in the world of real estate. These are the reasons: You may not be saving as you think. Some shareholders in S corporations cannot deduct the losses of the corporation from their income statement. That means the protection which the investor hopes to achieve will be lost. There is also of course the limit on the number of shareholders which can be off putting for larger or growing corporations. Additionally, the other restrictions, of shareholders (i.e. citizens of US), and of the type of stock are also disadvantages.
- Cannot deduct losses
- Limit on number of shareholders
- Shareholders must be US Citizens
- Only one class of stock
Real Estate S Corporation: Profiting with Flipping
The most popular application of s corporations is for flipping. This means that people who buy and renovate houses in a short period of time are well served. That is because, often flips are subject to heavy taxes, and very few tax deductions. S corporations can counter this issue.
Flipping – Must be Done with an S Corporation
As mentioned above, the S corporation is well-suited for “real estate flipping.” When properties are flipped, they are considered inventory and the investor is considered a “dealer.” A real estate dealer who is not working under an S corporation is misses out on these advantages of the s corporation.
Why is an S Corporation best for Flipping?
You can save on self-employmetn tax (15,3% of your income). This is distinct from your income tax. If you profit 100000, as an LLC, you will hvae to pay both income and self-employment tax, which you, of course, would like to avoid.
Taxes: S Corporation
Of course, again, the biggest advantage of S corporations is that you can avoid the self-employment taxes which you otherwise have to pay as a real estate investor.
- Self-Employment Taxes
- How to Save Taxes with S Corporations
Biggest Tax Savings with S Corporations – Self Employment Taxes
When you become an S corp you immediately mitigate your self-employment taxes. This happens because, when you become an S corp you can split your income from the dividends you make. The dividends are not subject to self-employment taxes. Your salary still is of course, but this is less.
Want to save more on real estate taxes
How to Save Taxes with S Corporations
To understand fully how these tax advantages function, take a look at this video below. It explains the possibilities you have to save the most with an S corporation.
Example S Corporation – Explained
Let’s say John and Jane form an S corporation. They share ownership equally at 50/50. Jane contributes $950.000 in cash. John on the other hand, contributes $950.000 worth of real estate that is encumbered by a $850.000 mortgage, with the original amount being $600.000. The mortgage is now taken into the S corporation. That means that John is free of debt, in fact, the mortgage is higher than his cost in the property, so theoretically, he will make a gain of $250.000. Also note, that this contribution is tax-free. Now this may be unfair, or undesirable, but it is one of the facets of S corporations.
S Corporation Summary: Avoid Self-Employment Taxes
There are many advantages to S corporations, but also disadvantages. The most important thing is to get informed beforehand about what the best type of entity is for you and your purposes. If you intend to flip a house, it is almost certain that an S corporation is the route you will want to take.
Comparison: S Corporation or LLC?
S corporations are often compared with the ubiquitous LLC. They differ heavily, and provide different advantages. To compare read our article