There are many entity types to choose from when you’re ready to start purchasing real estate. However, beware, some are much worse than others. In our Real Estate blog series we’ll begin with why it’s not a good idea to set up a corporation in which real estate will be held. Later on in the Series, the blog posts will discuss why LLCs should be the route you choose. But first, why not a corporation?
The Pain of Double Taxation
A normal C corporation is not a pass-through entity and, therefore, taxable income is initially taxed at the corporate level.
However, if the corporation distributes its earnings to its shareholders as a dividend, the recipients of the dividend must include it in their individual taxable income – subject to income taxes a second time at the personal level. Ouch.
Appreciation is Normally Good
If an asset that appreciates in value is held inside a corporation and the real estate asset is later sold by the corporation at the appreciated value, the gain will be taxed at the corporate level at corporate income tax rates.
If the corporation subsequently distributes income to its shareholders, for example as a dividend, the recipients will include in their individual taxable income where it will be subjected to income taxes a second time.
Example:
- You own property in your C corporation
- The C corporation sells the property and realizes a gain of $15,000
- The corporation’s income tax rate is 15 percent
Result:
- Corporate income tax is: $2,250 (15 percent x $15,000)
- The C corporation pays you a dividend of $12,750 (the gain of $15,000 minus the $2,250 in taxes)
- Your personal tax rate is also 15 percent
- Your personal income tax is $1,912.50 (15 percent x $12,750)
- Total Tax Paid: $4,162.50 ($2,250 + $1,912.50)
- That’s almost 28 percent of the $15,000 gain ($4,162.50/$15,000)
Now assume the same facts, except, you’re organized as an LLC (a pass-through entity and you have not elected to be taxed as an S-corp). Assume your personal tax bracket is 15 percent.
Result:
- Your tax is $2,250 (15 percent x $15,000 gain)
- The LLC entity is not subject to tax because it is a pass-through entity
Bottom Line:
- You save $1,912.50 by being organized as an LLC rather than a C corporation.
- You can’t reap all the benefits of real estate appreciation when it’s held in a C corporation.
There are other tax implication which we’ll discuss in future blog posts. Also, this is not intended as tax advice because each real estate deal is unique. As always, consult a CPA for your personal situation and consult an attorney for the legal ramifications of the entity choice.
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