Why Putting Real Estate in an S-Corp Is a Terrible (and Irreversible) Mistake
Meta Description: Learn why holding rental properties in an S-Corporation creates unfixable tax problems. Discover the right entity structure for real estate investing.
The Irreversible Tax Trap
A CPA called me last year on behalf of his client. The client owned 8 rental properties—all held inside an S-Corporation. The CPA had just realized the massive tax problem this created.
"Can we fix this?" he asked.
The answer: No.
Once you put real estate into an S-Corp, you can't get it back out without triggering enormous tax consequences. The mistake is essentially irreversible.
This client would face approximately $180,000 in taxes to unwind the structure. Money that could have been avoided entirely with proper planning from day one.
Why CPAs Recommend S-Corps (And Why They're Wrong for Real Estate)
S-Corporations are excellent entities for many businesses. That's why CPAs often recommend them:
S-Corps work great for: - Service businesses (consulting, law, accounting) - Companies with W-2 employees - Businesses with significant ordinary income - Active business operations
The S-Corp advantage: You can pay yourself a "reasonable salary" (subject to payroll taxes) and take the rest as distributions (no payroll taxes). On $200K in business income, this might save $15,000-20,000 per year in self-employment taxes.
So CPAs think: "S-Corp saves taxes. Client has rental properties. Rental properties should go in S-Corp!"
What they miss: Rental real estate has completely different tax treatment than active businesses. The "benefits" of an S-Corp don't apply—and you create massive problems.
The 5 Problems with Real Estate in S-Corps
Problem #1: No Benefit (You Don't Save Payroll Taxes)
The entire point of an S-Corp is saving payroll taxes on business income.
But rental income isn't subject to payroll taxes anyway.
Rental income is passive income. It's not subject to self-employment tax whether it's in an LLC, your personal name, or an S-Corp.
Example: - Rental income in LLC: $100,000 profit, $0 payroll tax - Rental income in S-Corp: $100,000 profit, $0 payroll tax
Tax savings from S-Corp: $0
You get zero benefit from the S-Corp structure. You just added complexity for no reason.
Problem #2: You Lose the Real Estate Loss Deduction
Most rental properties show tax losses in the early years due to depreciation, even when you have positive cash flow.
In an LLC or personal ownership: These losses can offset your other income (subject to passive activity rules and income limits).
In an S-Corp: The losses are trapped inside the corporation. You can only use them against future S-Corp income, not your personal income.
Example: You have a $150,000 W-2 job and your rental property shows a $20,000 tax loss (from depreciation).
- In LLC: $20,000 loss may offset your W-2 income (if you qualify), saving $4,000-7,000 in taxes - In S-Corp: $20,000 loss trapped in S-Corp, saves you $0 this year
You lose valuable tax deductions.
Problem #3: Built-In Gains Tax (The Real Killer)
This is where things get truly expensive.
When appreciated property is held in an S-Corp, any appreciation that occurred while in the S-Corp is subject to built-in gains tax when you sell.
The rule: If you sell appreciated property within 5 years of putting it in an S-Corp (or converting from C-Corp to S-Corp), you pay double taxation: 1. Corporate-level tax on the gain (21% federal) 2. Personal-level tax on the distribution
Even worse: This rule can apply in various situations even beyond 5 years.
Example: Property put into S-Corp at $300,000 value, sold 3 years later for $450,000 ($150,000 gain).
- In LLC: Pay capital gains tax once at 15-20% = $22,500-30,000 - In S-Corp: Pay corporate tax PLUS personal tax = $40,000-50,000+
You pay double tax on the same gain.
Problem #4: No 1031 Exchange (Or It's Extremely Complicated)
Section 1031 exchanges allow you to defer capital gains taxes when selling one investment property and buying another.
The problem: 1031 exchanges don't work (or are extremely limited) when real estate is held in an S-Corp.
Technically, when an S-Corp sells property, the S-Corp would need to do the 1031 exchange—buying another property that stays in the S-Corp. You personally can't do a 1031 exchange on S-Corp property.
This eliminates one of the most powerful tax deferral strategies in real estate investing.
Most investors: Sell properties over time, rolling gains into larger properties via 1031 exchanges, deferring taxes indefinitely.
S-Corp owners: Pay tax on every sale. No tax deferral strategy available.
Over a 20-year investing career, this could mean hundreds of thousands in unnecessary taxes paid.
Problem #5: You Can't Get the Property Out Without Massive Taxes
This is why the mistake is "irreversible."
To get property out of an S-Corp and back to you personally (or into an LLC), you must:
Option A: Distribute the property - Treated as sale at fair market value - S-Corp recognizes gain on distribution - You recognize income on the distribution - Could trigger built-in gains tax - Results in huge tax bill with no cash (you didn't actually sell, you're just moving it)
Option B: Dissolve the S-Corp - Same tax consequences as distribution - May trigger state-level taxes - May have complications with lenders
Option C: Sell the property to yourself - Must be at fair market value (or IRS will adjust) - Triggers all the same taxes - Plus you need financing or cash to "buy" your own property
Example of the damage: 8 properties in S-Corp, current value $2.4M, original basis $1.5M, equity $900,000.
To move these properties out of the S-Corp: - Taxable gain on distribution: $900,000 - Federal + state taxes: $180,000-270,000
You write a check for $180,000-270,000 just to fix the structure. You didn't sell anything. You didn't get any cash. You just paid taxes to move your properties from one pocket to another.
That's why it's essentially irreversible.
What About Active Real Estate Businesses?
There is ONE scenario where an S-Corp might make sense for real estate:
Active real estate businesses like: - Property management companies (managing for others) - Real estate brokerage - House flipping (buying, renovating, selling—inventory, not investment property) - Development companies
These are active businesses, not passive rental activities. The income is subject to self-employment tax, so the S-Corp payroll tax savings actually apply.
But even then: Keep rental properties separate. S-Corp for the active business, LLC for the rental properties.
The Right Structure for Rental Real Estate
For buy-and-hold rental properties, use:
Single-member LLC (or multi-member if partners): - Pass-through taxation (no entity-level tax) - Rental income taxed once at personal rates - Losses can offset other income (subject to passive activity rules) - 1031 exchanges available - Depreciation deductions flow through - Can move properties between LLCs if needed (still triggers taxes but much simpler)
Series LLC (for 3+ properties in Texas): - Same tax treatment as regular LLC - One tax return instead of multiple - Asset protection between series - Lower formation and maintenance costs
What you DON'T use: S-Corporation for rental real estate
How This Mistake Happens
Scenario 1: The Overeager CPA
Client: "I'm starting to invest in rental properties."
CPA: "You should have an S-Corp to save taxes!"
Client: "Okay, great!"
[CPA sets up S-Corp, properties go into S-Corp, disaster ensues]
The CPA knows S-Corps save taxes for service businesses. They don't realize rental real estate has different tax treatment.
Scenario 2: The Existing S-Corp
Client has an S-Corp for their consulting business. Doing well, saving payroll taxes. Buys a rental property.
Client: "I'll just put the rental property in my existing S-Corp. Easier than setting up a new entity!"
[Property goes into S-Corp, creates future tax problems]
The client assumes keeping everything in one entity is simpler. It's not—it's a tax disaster waiting to happen.
Scenario 3: The Internet Expert
Client reads articles about S-Corps saving taxes. Decides to be sophisticated and form an S-Corp for their real estate investments.
[Forms S-Corp, starts buying properties in it, discovers the mistake years later]
Internet articles often discuss S-Corp benefits without specifying they DON'T apply to passive rental income.
Warning Signs You Might Have This Problem
You might have real estate in an S-Corp if: - Your CPA files Form 1120-S (S-Corp tax return) that includes rental properties - Your rental properties are owned by an entity that has made an S-Corp election - You receive a W-2 from your real estate entity - Your rental income appears on your personal return via Schedule K-1 from an S-Corp
Check your tax returns. If you see Form 1120-S with rental properties included, you likely have this problem.
What to Do If You Already Have Real Estate in an S-Corp
You have three options, all expensive:
Option 1: Leave it and deal with the problems - Accept you won't get the full tax benefits of real estate - No 1031 exchanges available - Plan for eventual built-in gains tax when you sell - May be least expensive option if properties haven't appreciated much
Option 2: Bite the bullet and get properties out - Distribute properties to yourself personally (or to LLCs) - Pay the taxes now - May make sense if: - Properties have minimal appreciation so far - You're in a lower tax bracket this year - The long-term benefits outweigh the current tax hit
Option 3: Liquidate over time - Sell properties while in S-Corp - Pay the taxes (including built-in gains tax if applicable) - Use proceeds to buy NEW properties in your name or LLC - No 1031 exchange, but at least you're resetting the structure going forward
There's no good option. They all involve significant taxes or lost benefits.
That's why preventing the mistake from the start is so critical.
The S-Corp Conversation Clients Should Have
Here's what should happen when you start investing in real estate:
Client: "I'm buying rental properties. My CPA suggested an S-Corp."
Advisor: "S-Corps are great for active businesses but terrible for rental real estate. Here's why..."
[Explains rental income isn't subject to payroll taxes, losses get trapped, built-in gains tax, no 1031 exchanges]
Advisor: "For rental properties, use an LLC. Pass-through taxation, you get all the deductions, 1031 exchanges work, no tax traps."
Client: "What about asset protection?"
Advisor: "LLC provides asset protection. S-Corp doesn't give you additional protection for real estate, just creates tax problems."
Client: "So LLC for real estate, S-Corp only if I have an active real estate business like property management or flipping?"
Advisor: "Exactly."
That's the conversation that prevents the problem.
The Real Estate Investor's Entity Menu
Here's the correct entity selection for different real estate activities:
| Activity | Best Entity | Why | |----------|-------------|-----| | Buy-and-hold rentals (1-2 properties) | Single-member LLC | Simple, pass-through tax, asset protection | | Buy-and-hold rentals (3+ properties) | Series LLC | Lower costs, same protection, easier management | | House flipping | S-Corp or LLC | Active business income, S-Corp may save taxes | | Property management company | S-Corp | Active business, payroll tax savings apply | | Real estate brokerage | S-Corp | Active business, payroll tax savings apply | | Real estate development | S-Corp or LLC | Depends on structure and income levels |
Notice: Buy-and-hold rental properties never use S-Corps.
Don't Make Irreversible Mistakes
In real estate, most mistakes can be fixed: - Bad tenants → evict them - Deferred maintenance → repair it - Wrong property → sell it - Bad market → wait it out
But wrong entity structure? Much harder to fix. Sometimes impossible without huge tax bills.
That's why getting the structure right from the beginning matters.
My policy on parachutes purchased at a discount: When will you find out it doesn't work? When you pull the ripcord.
The same applies to entity structure. When will you find out your S-Corp was the wrong choice? When you try to sell. When you try to do a 1031 exchange. When you try to unwind the structure. When you're writing a massive check to the IRS.
Get It Right From the Start
If you're starting to invest in real estate—or you've already made the S-Corp mistake and want to know your options—let's talk.
Free Entity Structure Consultation: I'll review: - Your current properties and structure - Whether you have the S-Corp problem (or other entity issues) - Correct structure for your situation - Cost to fix if needed - Tax planning for optimal structure going forward
📞 Call: 512-464-1110 📧 Email: david@pcfo.net 📅 Schedule: Book free consultation
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About David Disraeli: 40+ years protecting Texas investors. 180+ Series LLCs formed. 385+ properties protected. A+ BBB rating. Specializing in Texas real estate entity structuring and helping investors avoid costly entity mistakes.