As mentioned earlier, K-1 income from an S-Corp will be reported on Schedule E of your personal tax return since it is business investment income. If you do not materially participate in the S-Corp’s operations, this can be a huge windfall if you are a rental property owner too. How does this play into S-Corps? Here we go-
Let’s presume that you have a rental loss of $50,000. Rental income is typically considered passive, meaning that you are not directly earning the income as you would with a job. Passive losses may be deducted from non-passive income such as wages, but there are limits. Passive loss limits for married taxpayers max out at $25,000, and that number decreases as your gross income increases.
Specifically, passive loss reduces $1 for every $2 over $100,000 adjusted gross income and by $150,000 (for married filing joint taxpayers) the passive loss deduction is $0. Bummer. Not all is lost however.
Let’s also presume that you are a minority investor in an S-Corp that earned $50,000 and reported the income on a K-1. Let’s say you do NOT materially participate in the running of the S-Corp. Without the rental, you would be taxed on $50,000. Without the S-Corp you would only be able to deduct $25,000 worth of passive losses. But with both the rental and the S-Corp, you shelter $50,000 of your K-1 with your rental losses, and pay $0 tax. Cool, huh?
Granted, this is rare- most S-Corp shareholders actively participate and cannot offset their S-Corp income with rental losses. Although there might be some wiggle room with spouse A owning 90% of an S-Corp, for example, that he or she doesn’t materially participate in. The same spouse A could then own 100% of the rental properties. This can get convoluted for sure, and careful tax planning must be exercised.
As a side note, it is NOT a good idea to make an S-Corp election on your LLC if it owns rental property. Rental property by definition is passive income (unless you are a real estate professional as defined by the IRS) and therefore not subject to self-employment tax. But if you run your rentals through an S-Corp, you will be required to perform payroll and you’ll be paying Social Security and Medicare taxes which are the same as self-employment tax. Don’t do it. You’ll artificially increase your tax liability by essentially converting passive / unearned income into earned income.
Taxpayer's Comprehensive Guide to LLCs and S Corps