Should Real Estate Be Held in an S Corporation?

Should real estate be held in an S corporation? Usually not, and the reason is technical rather than obvious. A shareholder's basis in an S corporation only grows when the shareholder personally contributes cash or personally lends money to the company. A bank mortgage the corporation takes out on a property does not increase that basis, even though the debt is real and the entrepreneur may have personally guaranteed it. Because depreciation deductions are limited by basis, this quietly caps how much depreciation an S corporation can pass through on a property carrying substantial third-party debt.

Why Does an S Corporation Cap Real Estate Depreciation?

Many entrepreneurs hold real estate inside the same S corporation that runs their operating business, often because that entity already existed when the property was acquired and nobody revisited the choice. The problem shows up in the numbers. Say an S corporation buys a $2 million rental property using a $1.6 million bank mortgage and $400,000 contributed by its two shareholders. The shareholders' combined stock basis is roughly $400,000, the cash they actually put in. The $1.6 million mortgage is a debt of the corporation to the bank, not a debt the shareholders personally owe.

Under IRC Section 1366(d), a shareholder can only deduct pass-through losses, including depreciation, up to that shareholder's stock and debt basis. Once depreciation deductions exceed the $400,000 basis in this example, the excess is suspended, not lost, and carries forward until basis is restored. For a heavily mortgaged property, that ceiling can arrive quickly, even though the underlying debt is entirely real.

Why Doesn't a Bank Mortgage Increase an S Corp Shareholder's Basis?

This is the mechanical heart of the issue. Under IRC Section 1366(d)(1)(B) and the accompanying Treasury regulations (Treas. Reg. Section 1.1366-2), a shareholder only receives debt basis when the shareholder personally is the creditor and the loan is bona fide, meaning it runs directly from the shareholder to the corporation. A loan from a bank or any other third party to the corporation does not create basis for the shareholder, regardless of how the proceeds are used.

Personally guaranteeing the corporation's mortgage does not change this on its own. Per IRS guidance on S corporation stock and debt basis, a guarantee, surety, or similar accommodation does not create shareholder basis; basis is created only if and when the shareholder actually pays under that guarantee. This surprises entrepreneurs who assume a personal guarantee functions the same way a personal loan does. It does not.

How Does a Partnership or LLC Treat the Same Debt Differently?

A partnership, or an LLC taxed as a partnership, runs on a different basis system. Under IRC Section 752, a partner's outside basis includes the partner's share of the partnership's liabilities, not just what the partner personally contributed. For real property specifically, the at-risk rules under IRC Section 465(b)(6) treat "qualified nonrecourse financing" as amounts the partner is at risk for, even though no one is personally liable for repayment, as long as the debt is secured by real property used in the activity and borrowed from a qualified lender such as a bank.

Run the same $2 million property, the same $1.6 million mortgage, and the same $400,000 cash through a partnership instead, and the partners' combined outside basis can include their share of that $1.6 million, not just the $400,000 they contributed. The depreciation ceiling that applies inside the S corporation does not apply the same way here. Same property, same debt, a materially different basis and depreciation outcome, driven entirely by which entity holds the deed. For entrepreneurs weighing real estate alongside other private real estate and alternative investment decisions, this basis mechanics question is usually the first thing worth checking, before returns, before financing terms.

What Happens If You Try to Move the Property Out of the S Corporation Later?

The basis problem is not the only structural issue. Distributing appreciated real estate out of an S corporation, for example transferring title to an individual shareholder, is itself a taxable event at the corporate level under IRC Section 311(b), which is applied to S corporations through IRC Section 1371(a). The corporation recognizes gain as if it had sold the property to the shareholder at fair market value, even though no cash actually changed hands. That gain then passes through to the shareholders under the S corporation's normal pass-through rules, so the shareholder can owe real tax on a paper transaction.

Partnerships are generally more flexible here. Under IRC Section 731, a partnership distributing appreciated property to a partner typically does not trigger immediate gain recognition at the entity level, though this is not unlimited: the contributed-property rules under Section 704(c) and the disguised sale rules under Section 707 each carve out situations where gain is still recognized. The general design is still meaningfully different from the S corporation rule, which taxes the appreciation at the moment of distribution as a matter of course.

What Should You Do If Your Real Estate Is Already Inside an S Corporation?

I regularly walk entrepreneur clients through this exact issue, because it is one of the more common entity-arbitrage gaps we find when reviewing a business owner's full structure, the same "which entity should hold which asset" thinking behind the Arbitrage piece of our DEAPR tax-planning approach. Real estate usually belongs in a partnership or an LLC taxed as a partnership, not in an S corporation, precisely because of how basis and distributions work differently under the tax code described above.

This is not a do-it-yourself fix. Moving a property out of an existing S corporation to correct the structure can itself trigger the Section 311(b) gain this article describes, so any restructuring needs to be modeled before you act, not after. The information in this article is general and educational, not personalized tax or legal advice for your specific situation; if you hold real estate inside an S corporation, the practical next step is to have your CPA or tax advisor review whether that structure is costing you depreciation today or setting up a distribution-level tax trap for tomorrow, as part of the broader proactive planning we describe on our tax planning page. Separately, and worth noting since the two questions get conflated: the liability protection an LLC provides is a distinct question from which tax classification that LLC elects, and is covered in more depth on our asset protection page.