Partnership vs. S Corp: What’s Best for Holding Property?

Holding real estate in an S corporation may seem like a great idea when forming a new entity. 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. Why, then, do most professionals working with real estate investors recommend partnerships over S corporations as the most attractive vehicle to hold real estate?

Admittedly, properly structured partnerships offer the same advantages as S corporations when it comes to protecting an investor’s liability and avoiding double taxation. Although partnerships are not as effective as S corporations in reducing self-employment taxes, income from passive real estate investments is not subject to self-employment tax.  Also, like S corporations, property with fair market value exceeding investors cost basis (appreciated property) can be contributed to a partnership tax free.

Partnership becomes advantageous, however, when property subject to a mortgage is contributed to the entity. In case of the S corporation, if mortgage balance exceeds the cost basis of the contributed property, that excess creates taxable gain. This happens because mortgages do not increase a shareholder’s cost basis even when debt is guaranteed by the shareholder. The opposite happens with partnerships, as partners get an increase in their basis from debt they guarantee. An example best illustrates this concept:

James and Suzanne form an S corporation. Their ownership is 50/50. James contributed $800,000 in cash. Suzanne contributed a property worth $800,000 subject to $700,000 mortgage (for which she had originally paid $550,000). The S corporation assumes the mortgage and Suzanne is personally relieved of debt. Since the mortgage balance is higher than Suzanne’s cost basis in the property, she will recognize a $150,000 gain even though the contribution is otherwise tax free. If James and Suzanne formed a partnership instead of the S corporation, Suzanne’s cost basis would be increased by 50% of the mortgage balance and she would have no taxable gain.

Additionally, even when mortgage is not a problem, contribution of appreciated property to an S corporation is taxable if the contributing shareholder does not owe more than 80% of the corporation’s vote or value immediately after the transfer. This creates a problem when one shareholder contributes appreciated property and the other shareholder offers only so-called “sweat equity.” Tax law related to partnerships does not have the 80% requirement, so the problem can be avoided by using a partnership structure.

In situations when tax-free contribution of property can be accomplished by using an S corporation, partnership is still the more favorable option because a tax-free distribution out of the entity is allowed only in a partnership. A taxable event occurs when an S corporation with appreciated assets liquidates or one of the shareholders is being bought out. This may be a tough situation for shareholders when there is no cash distributed to pay for the tax liability. Once again, the situation can be avoided in a partnership structure, which allows for a tax free distribution. (It is important to note that tax-free distribution is just a deferral of tax until the property is actually sold.)

Another benefit of partnership is the election to step up the basis of partnership assets when a partner dies or someone buys partnership interest. When the election is made, the assets are stepped up to their fair market value. This is especially beneficial when the stepped-up assets are depreciable or amortizable property, because the increased basis will allow for higher depreciation deduction. There is no step-up in basis allowed for the assets of an S corporation when corporation’s stock changes hands.

Partnerships are also very flexible when it comes to allocating income and distributing capital (as opposed to S corporations that allow only for equal distributions of property and income according to ownership percentage). In complex real estate deals, S corporations do not come close to the flexibility that partnerships allow.

With so many advantages of partnerships over S corporations, it is no surprise that partnerships are very popular among real estate investors. However, it is also important to remember that there are limited instances when using S corporations makes sense in the world of real estate. S corporations can be a great alternative for those in business of flipping properties, managing properties, or developing real estate.

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