You have several options if you are buying a new home and want to use your previous house for rental property. One of these options is creating an S corporation. There are two huge reasons why you don’t want to simply convert it to rental property. These include:
- You won’t get to take advantage of the $250,000 (or $500,000 if you’re married) home-sale profit exclusion.
- You’ll have fewer tax deductions if you convert it directly since the depreciation basis will be lower.
If your home has appreciated since you first purchased it, you may be able to get both the exclusion ($250,000/$500,000) and a step-up in the depreciation basis when you sell your home to your S corporation. Please note that the S corporation is created by you. (More about that later.)
When you sell a home to your S corporation it triggers related rules that transform capital gain into an ordinary income. That appears to be a huge problem, but when we finish explaining the rules, you’ll understand how to avoid the problem. There are numerous considerations on your part, let’s take a look at them so you can achieve the financial and tax outcomes you desire.
4 Steps to Obtain a Tax-Free Gain
These four steps will make the gain on the sale of your home tax-free when you sell it to your S corporation.
Step 1: Form an S corporation. Make sure to keep this simple and inexpensive. Having your own S corporation gives you two tax pockets. You have a personal pocket and an S corporation pocket. Tax law sees your S corporation as a separate entity.
Step 2: Sell your home to your new S corporation. The sale should be used using a “contract for deed” or another instrument that is similar.
Step 3: Elect out of installment-sale reporting. When you elect out, the profits on the sale of your home are taxable immediately.
Step 4: Eliminate taxes. IRC Section 121 allows you to exclude $250,000 of profits from the sale from taxes. (That’s $500,000 if you are married and file jointly.) For example, if you sell your house to your S corporation for $400,000, it has a $400,000 basis since it’s going to turn it into rental property. The home-sale profit exclusion is $250,000. Using it helps you avoid paying taxes on the $200, 000 profit on the house.
S Corporation Funnels
An S corporation doesn’t pay federal taxes because it is a pass-through entity. It can be compared to a funnel. Income and expenses are put in at the top of the funnel. Then, the profits and losses that flow to the bottom are reported on your personal tax return. The S corporation will provide a K1 that will be entered on your taxes showing that you had profits and losses as an individual. Some states apply taxes to S corporations. Most of them don’t affect the benefits you reap from using this strategy. However, you do need to know the requirements in your state before you choose to create the S corporation.
S Corporation Formation
There are two basic steps to forming an S corporation. You’ll form a “regular corporation” then choose an “S corporation” status. A lawyer is helpful. Keep the process simple, it doesn’t require a lot, but a lawyer is beneficial for helping you ensure everything is in proper order. They can keep your minute book and ensure the corporation is in good standing. Once you have incorporated, you will need to file IRS Form 2553 to choose S corporation treatment. It’s best to have your accountant or lawyer file Form 2553 for you. You’ll need to:
- Make the S election effective for the tax year when the state recognized your corporation as a corporation.
- Make sure to file the S election within two months and 15 days of the date you incorporated.
- Choose a calendar year as the taxable year for your S corporation.
What about Cash?
If you need cash, you’ll want to refinance or obtain a second mortgage before you sell your home to your S corporation. Once the S corporation buys the home, it’s not yours anymore. Instead, the S corporation owns it.
What about the existing mortgage?
Some mortgages prohibit assumptions. Even worse, some have a “due on sale” clause that would require you to pay off the balance when you sell the home. You can avoid the “due on sale” clause by using a “contract for deed” or a wraparound mortgage. These keep the title from being transferred until the mortgage is paid off. That keeps the transaction just between you and your S corporation. You do not have to file any documents with authorities. Make sure to spend some time with a lawyer who understands real estate law, so you don’t get in a bind.
Bona Fide Sale and Sales Price
Don’t try to sell your house to your S corporation for less than fair market value, it’s a sham. Make sure you can prove the fair market value at the time of the sale. Take steps to prove that the sale was not a sham. Most likely, you’ll need an appraisal. Appraisers know how to value properties based on different purposes. The same piece of property may have different values based on the uses of the property and assumptions.
If you are carrying the mortgage, the S corporation needs to pay a down payment that is at least 10% of the purchase price. You will still need to follow the traditional sales methods including using a lawyer or title company to transfer the title. You’ll need title insurance, termite inspection, proration of taxes, and any other formalities consistent with your local real estate market.
Some Gain is Regular Income
When it comes to tax purposes, you and your corporation are related parties. As soon as you sell your home to your S corporation, you’ll trigger the related-party rule for depreciable assets. This rule changes capital gains into regular income. Selling your home involves both land and a building. Land is not depreciable, so it’s not subject to the rule. This means that the profit from the land sale is still capital gains.
Whether it’s considered capital gains or a regular income, you don’t want to pay taxes on it. This is where you use the $250,000 exclusion. It will help you avoid paying taxes on the sale of your home. The exclusion erases the taxable gain.
If your gains are more than the exclusion, you can still claim the exclusion and then:
- Determine the ratio of the land to the building.
- Apply the ration to the extra gain to find how much gain is attributable to the building and the land.
- The extra gain that you can attribute to the land is treated as capital gains.
- The extra gain that can be attributed to the building is ordinary income.
It’s Crucial to Elect Out of Installment-Sale Status
What if your gain on the sale is less than the home-sale exclusion? This should not be reported on the installment method for a few reasons:
- You can exclude the gain by using the $250,000 (or $500,000) exclusion.
- When you elect out – you make it clear that you are choosing to use the exclusion.
- Electing out demonstrates that the exclusion replaces the Section 1239 ordinary income part of the sale.
You do not have to elect out of the installment-sale reporting to get these results. We just recommend it since it excludes the gain altogether. To elect out, simply use IRS Form 8949 to report the sale to your S corporation. Most of the time, you don’t have to report it when you sell your primary residence and there are no taxes due. However, electing out, in this case, helps prevent any misunderstanding.
Turn Your Home into Rental Property
Since you know the house so well, it makes a great rental property for your S corporation. You won’t run into a lot of surprises pf home remodeling that you might encounter if you purchased another piece of property for a rental. You’ll also have larger depreciation deductions because your S corporation has a stepped-up basis. If you choose to sell the property later, you’ll be selling a Section 1231 asset. If that happens over a year after your corporation purchased it, the gains on the sale will be capital gains, and any losses will be treated as ordinary losses. That gives you the “best of both worlds!”