How You Hold Real Estate Decides How It’s Taxed

The entity you hold property in can feel like paperwork at closing. It decides how income is taxed while you own, what happens when partners come and go, and how much tax is due on the way out.

LLCs, partnerships, and corporations

Most real estate is held in LLCs. A single-member LLC is disregarded for federal income tax purposes, so its owner reports the property as if they held it directly. An LLC with two or more members is taxed as a partnership by default.

Partnerships are the usual home for investment real estate for practical reasons: one level of tax, owners can generally deduct losses supported by the property’s debt (Section 752 gives partners basis for their share of partnership liabilities), and property can generally move in and out without triggering gain.

Corporations work differently. A C corporation pays tax on its income, and shareholders pay again on distributions. An S corporation avoids the double tax but doesn’t give owners basis for the entity’s mortgage debt. Distributing appreciated property out of either kind of corporation generally triggers gain. That’s why corporations are usually the wrong home for appreciating real estate, with exceptions.

[Diagram placeholder: a common holding structure, with owners above a holding partnership and separate property LLCs below it]

Contributing property and built-in gain

Contributing property to a partnership in exchange for an interest is generally tax-free under Section 721. The gain doesn’t disappear, though. It becomes built-in gain: the difference between the property’s value and its tax basis on the day it goes in.

Say you contribute a building worth $10 million with a $4 million basis. There’s $6 million of built-in gain. Section 704(c) requires allocations to account for that gain, and the depreciation tied to it, generally so it stays with you rather than shifting to partners who join later. The partnership chooses a method for doing that, and the choice affects every partner’s K-1 for years.

Timing matters too. If you contribute property and receive cash or other property back within two years, the IRS can treat the transaction as a disguised sale under Section 707, triggering the gain you meant to defer.

Bringing in partners

Whether new money comes in as a capital contribution or as a purchase of an existing interest changes the result for everyone. A contribution adds to the partnership. A purchase is a sale by the existing partner, with its own gain and its own basis adjustments.

Owners outside the United States

Foreign owners add layers: withholding on property sales under FIRPTA, withholding on a partnership’s U.S. income allocated to foreign partners, and U.S. estate tax exposure on property held directly. Structures such as blocker corporations exist to manage these, and each one has its own cost. The right answer depends on who the owners are and where they live.

[Diagram placeholder: a foreign investor structure, with a foreign owner, a U.S. blocker corporation, and the property partnership]

Property in more than one state

Each state where you own property can require its own returns, withholding for nonresident owners, and entity fees. California, for example, requires withholding on certain payments to nonresident partners and on many real estate sales, and charges an annual tax on LLCs doing business in the state. Restructuring can also trigger property tax reassessment, which we cover in a separate guide.

When to revisit the structure

• Before bringing in new partners or investors

• Before a refinance or sale

• When an owner’s residency or family situation changes

• When the structure was built for a property you no longer own

Changing structure later is possible, but rarely free. The cheapest time to get it right is before the deal closes.