Sell Your Home to S Corporation and Then Make It a Rental Property

May 1, 2016

Used with permission from the Bradford Tax Institute

Are you upgrading to a new home? Would your previous home make a great rental property?

If so, don’t simply convert it to a rental property. Why? Two big reasons:

1.  You would miss out on the $250,000 ($500,000 if married) home-sale profit exclusion.
2.  You would have a lower depreciation basis and thus fewer tax deductions with a conversion.

If your home has appreciated in value since you bought it, you can get both some tax-free income using the$250,000/$500,000 exclusion and a step-up in your depreciation basis by selling your home to your S corporation. (This is the new S corporation you will create when you finish reading this article.)

The sale of your home to your S corporation triggers the related-party rules that turn capital gains into ordinary income. On the surface, that’s a problem. But when you know the rules that you will learn in this article, you’ll see how you can avoid this problem.

Actually, there are several things you have to consider. This article guides you through those so you can get the tax and financial results that you want.

 

Four Steps to a Tax-Free Gain

Here are four steps to making the gain on the sale of your home to your S corporation tax-free.

Step 1.  Form an S corporation.  Keep this simple and inexpensive.

Two pockets.  Now that you have your own personal S corporation, you have two tax pockets: your personal pocket and your S corporation pocket. Tax law treats your wholly owned S corporation as a separate legal entity.

Step 2.  Sell your home to your newly formed S corporation.  Most likely, you will make this sale using a“contract for deed” or similar installment-sale instrument. We’ll have more on this later.

Step 3.  Elect out of installment-sale reporting.  By electing out, you make the profits on the sale of your home immediately taxable.

Step 4.  Eliminate the taxes.  You eliminate the profits with IRC Section 121 that allows you to exclude $250,000 ofhome-sale profits from taxation ($500,000 if married, filing jointly).

Example.  Four years ago, you paid $200,000 for the home that you are going to sell to the S corporation for$400,000. Your S corporation has a $400,000 basis in the house that it’s going to turn into a rental property. You use the $250,000 home-sale profit exclusion to avoid paying taxes on the $200,000 profit.

The S Corporation Funnel

The S corporation is a pass-through entity. It doesn’t pay taxes at the federal level. Think of it as a funnel. You put the income and expenses in the top of the funnel, and out of the bottom, the profits and losses flow to your personal tax return.

On your federal tax return, the individual line items arrive via a K1 from the S corporation and land on different lines of your Form 1040 (pretty much as if you had the profits and losses as an individual).

Many states apply various types of taxes to the S corporation. For the most part, those additional taxes have little effect on the true benefits of this strategy, but it is worthwhile to know what your state is going to do to you before deciding to create an S corporation.

Forming the S Corporation

Forming the S corporation takes two easy steps:

1.  Form a “regular” corporation.
2.  Elect “S corporation” status.

Use your local lawyer or a lawyer who specializes in inexpensive incorporation to form the regular corporation(commonly called a C corporation). You don’t need anything exotic here. Keep it simple. But use a lawyer.

Also, engage the lawyer to help you keep your minute book in good order and the corporation in good standing.

Once incorporated, file IRS Form 2553 to elect S corporation treatment. Two rules of thumb here: ¹

  • Make the S election effective for the tax year beginning with the date that the State made your corporation a corporation.
  • File the S election within two months and 15 days of the date of incorporation.
  • Select a calendar year as your S corporation’s taxable year.

Note.  Your S corporation is most likely to have a short taxable year as its first taxable year. For example, in the first year, your C corporation is a corporation on May 5. You file your S election with two months and 15 days and make it effective on May 5, and you also select the calendar year. With these facts, your short year is from May 5 to December 31.

You can have your lawyer or your tax preparer file the Form 2553. You can also file the form yourself, but the lawyer or tax preparer is a better choice.

Regardless, make certain this filing gets done and gets done on time. One day late can cost you the favorable S corporation election.

 

The Question of Cash

If you need cash, take out a second mortgage or refinance your first mortgage before selling to your S corporation. Why before?

Once the S corporation has the home, it is no longer yours (the S corporation owns it).

 

The Existing Mortgage

Your existing mortgage may prohibit mortgage assumptions. Worse yet, it may contain a “due on sale” clause that requires you to pay off the balance when you sell it. Check your mortgage to see if it prohibits assumptions.

To avoid the “due on sale” clause, use a wraparound mortgage or a “contract for deed.” In these cases, title to the property does not transfer until the mortgage is paid in full. No sale or mortgage documents are filed with the authorities; thus, the transaction is strictly between you and your corporation.

The lack of a legal filing avoids the “due on sale” clause, but the sale by contract for deed counts as a sale for tax purposes.

If your mortgage prohibits mortgage assumptions or contains a due-on-sale clause, you should spend time with areal estate lawyer familiar with the mortgage rules so that you don’t get yourself in a bind.

Sales Price and Bona Fide Sale

If the sale of your home to the S corporation is not at fair market value, the sale probably is a sham. Make sure you have proof of fair market value at the time of sale and take steps to prove that the sale is not a sham.

More than likely, this is going to require an appraisal. Keep in mind that appraisers know how to value properties fora variety of purposes. The same property can have two different values, depending on assumptions and uses of the property.

If you are carrying the mortgage, make sure that the S corporation pays at least 10 percent of the purchase price to you as a down payment.

You should follow traditional sales methods such as title transfer with a lawyer or title company (if you are going to transfer title immediately), title insurance, a home inspection, proration of property taxes, termite inspection, and similar formalities found in your local real estate market.

Some of the Gain Is Ordinary Income

You and your S corporation are related parties for tax purposes. When you sell your home to your S corporation, you trigger the related-party rule on sales of depreciable assets. This rule turns capital gains into ordinary income. ²

The sale of your home is going to involve both building and land. Since land is not depreciable, the portion of the sale attributable to land is not subject to this related-party rule and the gain from sale of the land remains as capital gains.

Regardless of ordinary income or capital gains, you don’t want to pay taxes on this transaction. Here’s one easy-to-use tactic: simply use your $250,000 exclusion ($500,000 if married) to avoid taxes on the sale of your residence. The exclusion does not care whether that gain is capital gains or ordinary income. ³

In all cases, the exclusion erases the taxable gain. If your gain is greater than the exclusion, then claim the exclusion against the total gain and treat the excess gain as follows:

 

  • Find the ratio of land and building.
  • Apply the ratios to the excess gain to identify the gain attributable to land and building.
  • Treat the excess gain attributable to land as capital gains.
  • Treat the excess gain attributable to building gain as ordinary income.

Example. You sell your home for a $600,000 profit to your S corporation. You eliminate $500,000 of the gain using the combined $500,000 exclusion available to you and your spouse. Land accounts for 55 percent of the value of the property. Of the $100,000 gain not eliminated by the exclusion, you treat $55,000 as capital gains and $45,000as ordinary income.

 

Critical Step: Elect Out of Installment-Sale Status

If your gain on sale is less than your home-sale exclusion, you do not want to report this sale on the installment method for three reasons:

  • You can use the $250,000 ($500,000 if married) exclusion to exclude the gain.
  • Electing out makes it clear that you are using the exclusion.
  • Electing out makes it clear that the exclusion wipes out the Section 1239 related-party ordinary income component of this sale.

You are not required to elect out of installment-sale reporting to get these favorable results. We simply prefer the simplicity of electing out when you can exclude all the gain.
Electing out is easy. Simply report the sale of your home to your S corporation on IRS Form 8949. ⁴

Generally, you do not report the sale of your principal residence when you have no taxes due because of the exclusion. In this case, because you have the combination of ordinary income and installment-sale reporting, disclosure of this combination via the official electing-out method helps prevent any misunderstanding.

 

Make It a Rental

Your old home makes a great rental for your S corporation because you know the house. You are not going to suffer lots of surprises as you might if you simply purchased an unknown property as a rental.

And remember, your S corporation has a stepped-up basis in the rental equal to what it paid you for the property. This gives you larger depreciation deductions.

When you sell this rental, you are selling a Section 1231 asset, and if that occurs more than one year after purchase, Section 1231 treats gains on sale as capital gains and losses as ordinary losses. (As you likely noted, this gives you the best of both worlds.)

 

Takeaways

This strategy of selling your home to your S corporation and then making it a rental property allows you to:

  • retain the benefits of your home-sale exclusion and avoid taxes on up to $250,000 of home-sale profits ($500,000 for a married couple filing jointly), and
  • avoid the adverse effects of ordinary income treatment on this sale to a related party to the extent you can exclude gain by using the home-sale-profit exclusion.

Your S corporation receives a stepped-up basis equal to the price it paid you for the property. The higher basis increases the S corporation’s depreciation deductions, which flow to your personal tax return via the net income or loss reported on the K-1.

To achieve the benefits and pocket the profits, you need to take two steps:

 

  • Create a second pocket by forming an S corporation.
  • Sell the house to the S corporation.

If you need to make the sale to the S corporation while you continue to hold the original mortgage, you will likely sell using a contract for deed or wraparound mortgage, as advised by a lawyer in your area who specializes in real estate mortgage transactions. Tax law calls this the installment-sales method.

But with the S corporation strategy as laid out in this article, you should use your Form 1040 filing to elect out of the installment-sales method and report the entire gain as taxable on IRS Form 8949 (an attachment to your Form1040). With this reporting, you document the entire transaction, including the gain and the elimination of the gain with the $250,000 or $500,000 exclusion.

Bradford Tax Institute, May 2016

1  IRS Form 2553, Election by a Small Business Corporation (Rev. December 2013);
Instructions for Form 2553 (Rev. December 2013).
2  IRC Section 1239; Private Letter Ruling 8350084.
3  IRC Section 121.
4  For how to elect out, see IRS Pub. 537, Installment Sales (2015), Dated Mar. 4, 2016, p. 4; for the entries to make on IRS Form 8949 , see the Column (g)example on page 5 of the
Instructions for Form 8949 (2015), Dated Dec. 1, 2015.

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