C-corporations: recapture at ordinary corporate rates
A C-corporation that sells rental property pays tax on all gain at the flat 21% corporate income tax rate. C-corps do not have separate long-term capital gain rates or the special 25% cap on unrecaptured Section 1250 gain that individuals use. All depreciation recapture — and all capital gain — is taxed at 21% at the corporate level.
This means the tax treatment is simpler (no gain-splitting into recapture vs. long-term capital gain) but can result in a higher effective rate than for individuals in lower brackets. Additionally, when the C-corp distributes the after-tax proceeds to shareholders as a dividend, those dividends are taxed again at the shareholder level (generally 15–20% for qualified dividends). This double taxation is a key reason most tax advisers discourage holding real estate in a C-corp.
S-corporations: recapture flows through to shareholders
An S-corporation does not pay corporate income tax. The gain on a rental property sale flows through to shareholders on Schedule K-1 in proportion to their ownership. Each shareholder includes their share of the gain on their individual return.
Here is the critical point: even though the S-corp's gain flows through to individuals, the character of the gain is determined at the entity level. Depreciation recapture — both Section 1245 ordinary income recapture and unrecaptured Section 1250 gain — is separately stated on the K-1. The unrecaptured Section 1250 gain retains its 25%-maximum-rate character when reported on the shareholder's individual return. The S-corp does not pay an entity-level tax (except in certain states or in the rare case of built-in gains tax on conversions from C-corps).
The built-in gains trap for converted C-corps
If a C-corp converted to S-corp status and then sells appreciated rental property within five years of the conversion, the built-in gain at the date of conversion is subject to a corporate-level built-in gains (BIG) tax at the highest corporate rate (21%). This tax is imposed on the S-corp before the remaining gain passes through to shareholders. Properties that appreciated significantly during the C-corp period are particularly vulnerable.
If you are planning to convert a C-corp holding real estate to an S-corp, get an appraisal of the properties on the conversion date to document the built-in gain precisely — and plan to hold for at least five years post-conversion to avoid the BIG tax entirely.
A worked example: an S-corp sells a rental at a gain
An S-corporation owns a rental building it bought for $400,000 (excluding land), claimed $120,000 of depreciation, giving a $280,000 adjusted basis. It sells for $520,000. The $240,000 gain is computed and characterized at the entity level: $120,000 is unrecaptured Section 1250 gain and $120,000 is long-term capital gain. Both are separately stated on each shareholder's Schedule K-1.
A 50% shareholder reports $60,000 of unrecaptured Section 1250 gain (taxed at up to 25%) and $60,000 of long-term capital gain (0/15/20%) on their individual return. The S-corp itself pays no federal income tax on the sale, absent the built-in gains tax. The character flows through intact — a key advantage of the S-corp over a C-corp, where the same $240,000 would be taxed at 21% and then taxed again when distributed to shareholders.
Why a C-corp is usually the wrong holder for appreciating real estate
Beyond the flat 21% rate on gain, a C-corp holding real estate faces two structural problems. First, double taxation: after the corporation pays 21% on the gain, distributing the proceeds to shareholders triggers a second tax on the dividend (up to 23.8% including the net investment income tax). The combined effective rate on appreciated real estate can exceed 39%.
Second, there is no step-up in basis for the real estate when a shareholder dies — only the stock gets a step-up, leaving the corporate-level gain trapped inside the entity. And appreciated property generally cannot be pulled out of a C-corp without triggering gain. These frictions are why advisers overwhelmingly favor an LLC (taxed as a partnership or disregarded entity) for holding rental real estate.
Pulling real estate out of a corporation triggers recapture
If you decide a corporation is the wrong holder, be aware that distributing appreciated real estate to shareholders is a taxable event. Under Section 311(b) for a C-corp, and the parallel S-corp rules, the corporation is treated as if it sold the property at fair market value — recognizing the full gain, including depreciation recapture — even though no cash changed hands. In an S-corp that gain flows through to shareholders; in a C-corp it is taxed at the entity and again as a distribution.
There is no tax-free way to move appreciated property out of a corporation to its owners. This 'easy to enter, expensive to exit' problem is one more reason not to title rental property in a corporation in the first place. If property is already inside a corporation, model the full exit cost — including recapture — before acting.
State entity taxes and pass-through entity elections
The federal S-corp is a pass-through, but several states impose entity-level charges: California levies a 1.5% franchise tax on S-corp net income (minimum $800), Illinois imposes a personal property replacement tax, and other states have gross-receipts or franchise taxes. These apply on top of the shareholders' individual state tax on the flow-through gain.
Many states now offer a pass-through entity (PTE) tax election that lets the S-corp pay state tax at the entity level and deduct it federally, working around the $10,000 SALT cap for the owners. Whether a PTE election helps on a one-time property sale depends on your state's rules and your other income. Coordinate the sale year with your state tax adviser to capture any available PTE benefit.
Shareholder basis, distributions, and using a loss
A shareholder can only deduct S-corp losses up to their stock and debt basis. Unlike a partnership, an S-corp shareholder generally does not get basis for the entity's mortgage debt — only for direct loans they personally make to the corporation. This can strand losses (including a large first-year cost-segregation loss) that a partnership structure would have freed up. Losses in excess of basis are suspended and carried forward until basis is restored.
Distributions of cash from an S-corp are generally tax-free to the extent of the shareholder's stock basis and the accumulated adjustments account, then taxed as gain. Track basis every year on Form 7203; a sale year with a large gain increases basis, which can allow suspended losses to be used and cash to be distributed tax-free. Reconcile basis before, during, and after the sale.
Better alternatives, and how real estate ends up in a corporation
Given the recapture, double-tax, and exit frictions, why do rentals end up in corporations at all? Usually by accident — an operating S-corp buys a building, or an owner forms an S-corp on generic advice without considering real estate specifics. The preferred structure is almost always a limited liability company taxed as a partnership (multi-member) or as a disregarded entity (single-member). An LLC gives liability protection, passes income and the character of gain through to owners, allows tax-free distributions of appreciated property in many cases, gives members basis for the entity's mortgage debt (unlike an S-corp), and preserves a step-up in the underlying real estate at death.
If real estate is already trapped in an S-corp, options are limited and each has a cost. You can distribute the property to shareholders (triggering gain and recapture at fair market value), sell it and distribute cash (same recapture, plus the S-corp basis rules), or simply hold the entity long term and plan around it. One partial mitigation: because S-corp stock receives a basis step-up at a shareholder's death, heirs who inherit the stock may face less gain than the decedent would have on a stock sale — though the corporation's underlying real estate gain is not itself stepped up. There is no clean, tax-free fix, which is exactly why the entity choice should be made before the property is acquired.
Frequently asked questions
Does a C-corp pay the 25% recapture rate on Section 1250 gain?
No. C-corps do not have preferential capital gain rates. All gain, including unrecaptured Section 1250 gain, is taxed at the 21% flat corporate rate.
Does an S-corp pay the 25% recapture rate?
S-corps are pass-through entities. The unrecaptured Section 1250 gain flows through to shareholders and retains its 25%-max-rate character on their individual returns.
What is the built-in gains tax?
A corporate-level tax on an S-corp that converted from a C-corp, applied to appreciation that existed at the time of conversion if the property is sold within five years of conversion.
Is distributing rental property out of an S-corp taxable?
Yes. The corporation is treated as selling the property at fair market value, recognizing the full gain including depreciation recapture, which then flows through to shareholders. There is no tax-free way to remove appreciated property from a corporation.
Does an S-corp shareholder get basis for the property's mortgage?
Generally no. Unlike a partnership, an S-corp shareholder gets debt basis only for loans they personally make to the corporation, not for the entity's third-party mortgage. This can limit the losses a shareholder is allowed to deduct.
Do states tax S-corp rental gains at the entity level?
Some do. California, Illinois, and others impose franchise, replacement, or gross-receipts taxes on S-corps in addition to the shareholders' individual tax. Many states also offer a pass-through entity tax election that works around the federal SALT cap.
Is an LLC better than an S-corp for holding a rental?
Usually, yes. An LLC taxed as a partnership or disregarded entity passes through the character of the gain, allows tax-free distributions of appreciated property in many cases, gives owners basis for the mortgage debt, and preserves a step-up in the real estate at death — advantages an S-corp does not offer.
Does the built-in gains tax apply to an S-corp that was never a C-corp?
No. The built-in gains tax applies only to an S-corp that previously operated as a C-corp and sells appreciated property within five years of the S-election. An entity that was an S-corp from formation has no built-in gains exposure.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.