Can an S-Corp Help Avoid Capital Gain Taxes

The Mortgage-Pro · Site Admin Joined: 19 Jan 2005 Posts: 2248

By JUNE FLETCHER
Special to RealEstateJournal

Question: Three years ago I purchased a fourplex, and I live in one of the apartments. I want to sell it. I believe one-quarter of the capital gains from the sale is tax-exempt because it's my primary residence. Can I create an S-Corp and use the remaining capital gains to buy and sell property? My goal is to avoid capital-gains taxes without having to buy another multifamily home.

-- Gary, Phoenix

Gary: You're a smart investor. By buying a fourplex, you've not only had a chance to choose your neighbors, you've also gotten them to pay for a good chunk of your mortgage. And now, understandably, you want to protect your capital gains from the tax man.

So let's summarize your situation. Let's say you bought your unit three years ago for $400,000, and each unit is valued equally at $100,000. Now let's assume you sell the property for $800,000. You'll have a $400,000 capital gain, with $300,000 reportable to the Internal Revenue Service, and $100,000 excluded under principal-residency rules (the IRS requires that you live in your home at least two out of the past five years, a test you've passed). The $300,000 is subject to a maximum 15% federal tax. If you rented the units during your tenure, the math would change due to depreciation, but the concept remains the same.

To maintain this favorable capital-gains status on the future purchase of properties, you don't need to create an S-Corp. But you could create one, if you have a valid business reason (renting out properties qualifies). The reason for creating an S-Corp would be to minimize personal liability in the purchase of future properties. But it may not make a lot of sense if you need to purchase a new principal residence because it would eliminate the capital-gains exclusion available on the sale of a principal residence (you must both own and use the property to avail yourself of this exclusion).

Granted, an S-Corp pays no taxes to the Internal Revenue Service. But as a shareholder, you will have to report income and expenses on Schedule E of Form 1040 and pay taxes on net income, plus, possibly pay a city or state corporate tax. Incorporating also will incur fees. To minimize them, consider doing the paperwork yourself. You can get the incorporation forms for most states atwww.blumberg.com.

If you're sure you want to incorporate, New York certified public accountant William G. Green has another suggestion: create a limited liability corporation, or LLC, instead. By doing this, the IRS will give you a choice on how you're to be taxed: as a sole proprietorship (you'll continue to file under individual rates), an S-Corp, a C-Corp (a regular corporation) or as a partnership (this requires two people -- a husband and wife qualify). "It's the best of all worlds," he says. Some of his developer clients hold real estate in as many as 20 separate LLCs.

However, you'll pay fees both to set up and maintain your LLC, and for a small investor, it may not be worth the bother. Mr. Green says a rule of thumb is to consider this option if you plan to buy three or more properties, or will have a total gross revenue of more than $100,000. At that threshold, it makes sense to pay the fees in order to gain protection of your income from the claims of creditors.

For more information about the best incorporation option for your situation, contact a local tax accountant.

-- Ms. Fletcher is a staff reporter for The Wall Street Journal. Her "House Talk" column appears most Fridays on RealEstateJournal.com.