Whether you’re investing in valuable California real estate for personal or professional reasons, it’s important to take the right approach to structuring and holding these assets. One option we rarely recommend is holding real estate in a corporation.
While corporations offer some legal protections, putting real estate inside a C or S corporation can create tax problems that are difficult—or even impossible—to unwind. If you ever want to sell the property, move it to another structure, or take it back out of the corporation, you’re likely to end up with a massive tax bill.
Real Estate Can Go In Tax-Free—But Not Come Out Tax Free
When real estate is transferred to a corporation, no immediate tax is triggered if the rules of Section 351 are met. This allows appreciated property to be exchanged for corporate stock without recognizing capital gain as long as the contributor controls at least 80% of the corporation after the transfer. On paper, that is a fair deal. But it’s only a deferral—any gain on the property still exists.
The problem shows up when it’s time to move the property out of the corporation. Whether the corporation sells the property or simply transfers it back to the shareholder, the IRS treats the property as if it were sold for its fair market value. The previously deferred gain gets taxed at the shareholder level upon distribution – the taxable gain is the original basis of the property minus depreciation, the difference of which is subtracted from the fair market value upon transferring the property out of the corporation. It’s a tax trap that can wipe out hundreds of thousands in value, especially because it can even result in double taxation if done with a C-corporation!
S Corporations Don’t Solve the Problem, Either
Some investors assume that using an S corporation instead of a C corporation avoids these tax traps. That’s only partially true. While S corporations generally avoid corporate-level tax, appreciated property distributed from an S corporation still triggers gain at the shareholder level – the gain passes through to the shareholder, who pays the tax on their personal tax return.
Even worse, if the S corporation is subject to the built-in gains tax (for example, if it recently converted from C corporation status), that gain may be taxed both at the entity and shareholder levels. Whether the property is distributed in a current or liquidating transaction, the IRS still treats the transaction as if the property were sold, and the tax bill follows. If you transfer the property out of the S-corporation after 5 years from converting from a C-corporation, the double taxation generally does not apply .The key point remains: once appreciated real estate is inside a corporation, there’s no clean way to get it out during your life.
LLCs and Partnerships Offer Flexibility Without the Tax Trap
Unlike corporations, partnerships provide far more flexibility for holding and managing real estate. Under Section 721, property can be contributed to a partnership without triggering gain, and, critically, appreciated real estate can later be distributed back to the contributing partner without an immediate tax event. Partnerships also offer favorable treatment when liabilities are involved, avoiding the rigid gain recognition rules of Section 357(c) that apply to corporations.
If the partnership distributes the property later, whether in the ordinary course of business or during a liquidation, no gain is recognized as long as the value of the property doesn’t exceed the partner’s tax basis. The deferred gain only becomes taxable if the property is sold in the future. That flexibility makes partnerships (or LLCs taxed as partnerships) the go-to structure for real estate investors who want to retain control while avoiding unnecessary tax consequences.
Effective Tax Strategy for California Real Estate Investors and Business Owners
Choosing the wrong legal structure can create a permanent tax trap if you hold or plan to acquire real estate. Corporations rarely make sense for real estate because they eliminate flexibility and increase tax exposure. A properly structured partnership or LLC can preserve value and create room to adapt to future changes. Contact Dahl Law Group to protect your real estate investments and ensure your tax strategy matches your goals.
Dahl Law Group
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- You Should (Almost) Never Hold Real Estate in a Corporation - April 4, 2025
