What Happens When You Die Leave This World And Your S Corporation Owns The Rental?

If your old home is now a rental property inside your S corporation, here are the good and bad things that can happen when you pass away.

Question 1

If I create an S corporation, sell my home to that S corporation, and then rent the home to a third party, don’t my heirs lose the step-up on the basis of the rental home when I die?

Answer 1

Here is the answer to why it is technically yes and practically no.

Cost of basis of home on the date you sold it to your newly formed S Corporation = $250,000

Selling price of home to your S Corporation at fair market value on the date of sale = $750,000

S Corporation’s basis in the rental house after purchase from you = $750,000

Cost basis of S Corporation shares = $750,000

The fair market value of the rental house on the date of death = $2,000,000

The fair market value of S corporation shares at date of death = $ 2,000,000

At the date of death, the S corporation owned one asset: a rental house with a fair market value of $2,000,000.

For estate tax purposes, you determine the value of this S corporation based on the fair market value of the assets that it owns. In this case, the S corporation’s sole asset is one rental property with a fair market value of $2,000,000. Therefore, the value of the S corporation at the date of death is $2,000,000.

Your heirs inherit the S corporation stock with a basis of $2,000,000. That’s good

But the S corporation continues to own a rental house with a basis of $750,000 that’s worth $2,000,000. When you get the step-up in basis of the S corporation stock, you don’t get a corresponding increase in the value of the S corporation’s assets on the S corporation’s books.

At this point, it appears there is no step-up in basis. But in fact, as you will see the answer to the next question the result is the same you would get with a step-up in basis that eliminates the federal tax.

Question 2

What happens if my heirs sell the rental property for $2,000,000?

Answer 2

First, your heirs are not selling the rental property. The S Corporation is selling the rental property. The results when rental property is sold are:

The S corporation sells the rental for $2,000,000 and reports a $1,250,000 long term capital gain on Form 4797.
The $1,250,000 gain increases the shareholders’ basis in the S Corporation to $3,250,000
The S Corporation shareholders liquidate the S corporation by distributing the $2,000,000 from the sale to the shareholders causing a $1,250,000 long-term capital loss.
The $1,250,000 capital gain and the $1,250,000 capital loss offset, so the shareholders pay zero tax- and achieve the effect of a step-up in basis.

Takeaways

The tax professionals generally don’t want the S corporation to own a rental property or other appreciating assets.

In case where the taxpayer is employing the “sell home to S Corporation” strategy and turning the home into a rental property, the common complaint of no step-up in basis at death is likely overcome by a sale of the property and liquidation of the S corporation.