Schedule E, Partnership, or S Corporation for Real Estate Investors: Pros and Cons

Key Points

• Schedule E and Partnerships offer tax simplicity, passive income benefits, and better use of debt for rental real estate.

• S Corporations may reduce self-employment taxes for active investors but add complexity and reduce debt-related tax benefits. 

• Entity choice impacts liability protection, 1031 exchanges, and long-term planning. 

Understanding the Basics

• Schedule E reports supplemental income and loss and is used by individual taxpayers to report rental income and expenses from properties they own personally or through a disregarded entity like a single-member LLC.
• Partnerships involve multiple members who report rental income and expenses from properties they own through a general partnership, LP, LLP, or LLC.
• S Corporation taxation involves forming a legal entity and electing to be taxed under Subchapter S of the Internal Revenue Code. This allows owners to take a salary and potentially reduce self-employment taxes.

Pros and Cons of Schedule E and Partnerships

Pros:

• Debt basis: The largest benefit of putting rental activity on a Schedule E or Partnership tax return is that third-party debt can give the investor additional basis to take losses. It is very common for the investor’s capital account to go negative in rental activity. 
• Distributions are at cost basis: If two partners decide to go their separate ways, but they would rather not sell appreciated real estate, they can do so in a partnership setting without immediate tax implications.
• Simplicity and lower administrative costs: Reporting rental income on a Schedule E tax return requires minimal paperwork and avoids the costs associated with entity formation, payroll, and corporate tax filings. Partnerships are an additional tax filing, but no payroll is required, so there is less paperwork/compliance compared to S Corporations.
• Passive income tax treatment: Rental income reported on Schedule E or Partnership tax returns is generally considered passive income, which is not subject to self-employment tax (15.3%).
• No payroll requirements: Schedule E and Partnership filers do not need to pay themselves a reasonable salary, avoiding payroll tax complexities.
• 1031 exchange eligibility: Investors using Schedule E can take advantage of 1031 exchanges to defer capital gains taxes when selling a property. Partnerships are more complex since all partners generally need to agree on using this exchange.

Cons:

• Limited liability protection: If the property is held in an individual’s name instead of an LLC, the investor may be personally liable for legal claims.
• No self-employment tax savings on active real estate businesses: If an investor is actively involved in property management from third parties (not their own rentals), their income may be classified as non-passive and subject to self-employment taxes on Schedule C (if sole proprietor) or page 1 of the Partnership return.

Pros and Cons of Electing S Corporation Taxation

Pros:

• Self-employment tax savings: S Corps allow owners to split income between salary (subject to payroll taxes) and distributions (not subject to self-employment tax), potentially reducing tax liability. This only applies if the entity is doing more than just renting real estate (for example, they are a property management company and/or flipping properties).
• Stronger liability protection: Holding properties in an S Corp provides a corporate layer of protection against lawsuits and creditors. However, an LLC provides a layer of protection as well, whether reported on a Schedule E or a partnership tax return.

Cons:

• Loss of debt basis: The largest downside to putting real estate in a corporation structure is that any third-party debt is not considered basis to the S Corp owner. It’s very common for the investor’s capital account to go negative in a rental activity, so this is a significant inconvenience.
• Distributions are at fair market value: Distributions of property to an owner of an S Corporation are at the property’s fair market value. This creates a phantom tax situation in that the owner will pay income tax on something they didn’t sell.
• Payroll and compliance requirements: S Corp owners must pay themselves a “reasonable salary,” which requires payroll setup and associated tax filings.
• Administrative costs: Filing corporate tax returns (Form 1120-S), maintaining meeting minutes, and complying with S Corp regulations add complexity and cost.
• 1031 exchange complications: 1031 exchanges can be more complicated due to entity ownership of the real estate.
  
  

Final Considerations

• State-specific tax considerations: Some states impose franchise taxes or additional fees on S Corps that may offset potential tax savings.
• Long-term exit strategy: If you are planning to pass real estate assets to heirs, Schedule E and Partnership returns offer more flexibility in benefiting from stepped-up basis rules upon inheritance.

Choosing between Schedule E, Partnerships, and S Corporation taxation depends on an investor’s specific situation. Schedule E and Partnerships offer simplicity, passive income tax benefits, and flexibility for investors, no matter the number of rental properties. Meanwhile, an S Corp may be beneficial for investors actively engaged in real estate business operations. Before deciding, real estate investors should consult with a tax professional to evaluate the best strategy based on their unique situation.

About the Author

Randall joined Trout CPA in 2011. He graduated from Millersville University with a Bachelor of Science degree in Business Administration (magna cum laude) in 2006. Randall has over 19 years of accounting experience. He currently serves on the firm's Construction and Real Estate, Manufacturing, and Estate & Trust Practice Groups. As a Partner, Randall manages all aspects of tax planning and preparation and business consulting for some of the firm's significant clients.