At Anomaly you've probably heard us say that holding real estate in a corporate structure can often lead to significant tax complications including the loss of valuable deductions, less favorable basis adjustments, and limitations on capital gain exclusions. However, there are two carefully structured exceptions that allow you to harness tax benefits while still maintaining a corporate form.  

For individual taxpayers and passthrough entities (such as partnerships, S corporations, and LLCs), the Internal Revenue Code’s Passive Activity Loss (PALs) rules often disallow or suspend losses from rental real estate when those losses exceed the income generated from passive activities. This limitation can be VERY frustrating if you are managing high-income activities with a portfolio of real estate investments. 
Fortunately, a closely held C corporation (other than a personal service corporation) is granted the ability to utilize passive losses against its net active income, though not portfolio income (think interest, div, cap gain).}

How this Strategy Works

1. Transferring the Activity:
   1.  The strategy involves contributing an interest in a loss-generating rental real estate activity (such as a partnership holding an apartment complex) to a profitable, closely held C corporation via a tax-free Section 351 exchange. By doing this, losses that would otherwise be suspended at the individual level become eligible to offset the corporation’s active income.
      
      
2. Utilizing Passive Losses:
   1.  Under the rules applicable to closely held C corporations (defined as those where more than 50% of the value is owned by five or fewer individuals during the latter half of the tax year) the passive losses are immediately available to offset active earnings. This immediate offset can provide significant current-year tax benefits, although any losses already suspended remain suspended until there is sufficient passive income or until the activity is ultimately sold.
      
      

Quick Example

Imagine you are an investor named who holds a 50% interest in a partnership that owns a 50-unit apartment complex. 

 

The rental operation generates approximately $50,000 in losses annually. However, because your Adjusted Gross Income (AGI) surpasses the limits for the special $25,000 real estate loss allowance, these losses are suspended under the PAL rules. At the same time, you own 100% of T Co., a profitable C corporation engaged in manufacturing specialty sporting goods, with active net income expected to be about $250,000 for the current year.

 

By contributing your interest in the rental activity to T Co. through a Section 351 exchange, T Co. now becomes the owner of the passive loss activity. As a closely held C corporation (provided it qualifies as such and is not a personal service corporation), T Co. can use those suspended losses to offset its active income, leading to a potentially significant reduction in taxable income. Any suspended losses carried over remain available to offset future gains or income if the asset is later disposed of to an unrelated party.

Background

A common issue is the loss of the IRC Section 121 gain exclusion available on the sale of a primary residence when converting to a rental property, which is often a great idea. 
However, by converting a primary residence into a rental asset through an S corporation, it is possible to “lock in” this exclusion while simultaneously obtaining a stepped-up basis for the property.

How this Strategy Works:

1. Sale of the Primary Residence to an S Corporation:
   1.  In this strategy, you first sell your primary residence to your newly formed S corporation. Because S corporations are pass-through entities, the transaction can be structured so that you “lock in” the IRC Section 121 gain exclusion on any qualifying gain from the sale, provided that the property meets the ownership and use requirements (typically, living in the home for at least two out of the last five years).
      
      
2. Locking in a Step-Up in Basis:
   1.  Additionally, the transaction can result in a step-up in basis for the property within the S corporation. This means that subsequent depreciation or gain on a future sale is calculated against the new, potentially higher basis rather than the original cost. With the exclusion effectively “locked in,” the S corporation holds the property with tax attributes that can lower future taxable gains should the property appreciate.
      
      

Quick Example

Consider a scenario where you have resided in a home for many years, and you plan to convert the property into a rental investment. By selling your primary residence to your own S corporation, you can capture the IRC Section 121 exclusion on gain up to the exclusion limits (currently $250,000 for single filers or $500,000 for married couples filing jointly) if the necessary ownership and use tests are met. Post-transaction, the property enters the S corporation with a stepped-up basis. This approach not only preserves the gain exclusion that you would have lost in a traditional corporate sale but also resets the basis for future calculations of gain or depreciation.

Both strategies present thoughtful exceptions to the general drawbacks of holding real estate in a corporate structure. The closely held C corporation strategy can be particularly effective for offsetting suspended rental losses against active income, while the S corporation strategy offers a unique way to secure the IRC Section 121 gain exclusion and benefit from a stepped-up basis when converting a primary residence into a rental property.

 

These are two niche strategies that we have put into practice at Anomaly for specific situations.  If these could apply to you...be sure to reach out to your Anomaly PM!