Rental Property In C Corporations

By Jason Watson, CPA

We have seen some real estate investors leverage the C corporation in similar fashion. They inject a bunch of cash into the entity, and then buy a gaggle of rental properties with cash and debt. Every spare dollar is used to pare down debt, and any taxable income (rental profits) is paid at 21%. Later they elect S Corp status on the entity, wait 5 years for the built-in gains (BIG) tax waiting period, and then sell the rental properties at individual long-term capital gains rates (plus depreciation recapture).

Can you still do that big cost segregation study with that big depreciation deduction? Yes. Does it have the same thrill? Not really if you are currently at a 37% marginal tax bracket with your personal income. In other words, the wow factor at 21% is not the same as 37%.

What makes matters worse is that your rental property is likely to have losses in the early years, and to pile on with accelerated depreciation does nothing for you. In other words, to accelerate deprecation to accelerate your cash flow by lowering taxes requires taxable income. This is usually in the form of W-2 wages found on an individual tax return (Form 1040) and not a corporate tax return (Form 1120).

Of course, this assumes passive activity loss limits are being bypassed with real estate professional status or short-term rental loophole. Conversely, if you cannot accelerate your cash flow and you want to plow excess cash back into debt reduction, the C corporation might work.

Do you miss out on the Section 199A qualified business income deduction (QBID)? Yes. But consider the highest tax bracket of 37% multiplied by 20% yields a 7.4% delta which is still less than the delta between 37% individual tax rates and 21% C corporation tax rates. You might not benefit from the QBID if you are in the 37% marginal tax bracket given the secondary testing starting at the 32% marginal tax bracket.

Stessa and some other real estate CPAs say Never to rentals and C Corps. WCG CPAs & Advisors disagree. However, super duper careful tax planning is necessary. A crystal ball helps too.

There might be an issue with accumulated earnings tax (AET), but don’t get too hung up on that since depreciation will reduce earnings (tax loss or tax neutrality, but cash “gain”). Then later on down the line you elect S Corp tax status on this C Corp and you have the best of both worlds… reduced income tax for some time, and then avoided double taxation as you start pulling out excess cash from rental income or from property sales.

As you look to other investors and players in your real estate property purchase, don’t forget the golden rule where the person who has the gold makes the rules. Said differently, if an investor or venture capitalist wants to put their money with you, and they will only do so under a C corporation regime, you are stuck between a rock and a hard place.