By Jason Watson, CPA
Posted Saturday, March 21, 2026

While, or whilst as the Brits say, WCG CPAs & Advisors encourages short-term rentals to be owned by partnership entities, there are some problems to be aware of. Disadvantages of partnerships and multi-member LLCs owning rental properties include the additional tax return preparation fees and perhaps unnecessary state taxes such as California’s franchise tax and LLC fee which can be summarized as money-grabs or “pleasure to do business in our state” fees. You need to consider your state exposure versus the cost of reducing your federal exposure and therefore subsequent risk.

Section 179 Surprises

There is a wrinkle with IRC Section 179 when you hold a rental property inside a multi-member LLC (MMLLC) taxed as a partnership. Unlike depreciation, which can freely create a loss, Section 179 has built-in limitations that can restrict how much benefit you actually get.

The instructions for Form 4562 Depreciation and Amortization, reads-

Partnerships. Enter the smaller of line 5 or the partnership’s total items of income and expense, described in section 702(a), from any trade or business the partnership actively conducted (other than credits, tax-exempt income, the section 179 expense deduction, and guaranteed payments under section 707(c)).

What does this mean? The partnership must first determine its trade or business income, and that income effectively caps how much Section 179 can be allocated. Unlike bonus depreciation, which can push the entity into a loss, Section 179 has a second layer of friction-this time at the partner level.

While the partnership allocates Section 179 deductions through the K-1, each partner must apply their own limitations under IRC Section 179(b)(3), along with basis, at-risk, and passive activity rules. Unlike depreciation, which often flows through more cleanly, Section 179 deductions from a partnership can become effectively trapped depending on the partner’s individual tax situation and the character of the income they have available to absorb it.

Sidebar: Think you can avoid a partnership return by assigning your LLC interests to a joint revocable trust? Think again. In common law states, the IRS disregards the trust and sees two distinct owners (the spouses) under IRC Sections 671–679, mandating a Form 1065 partnership filing per Treasury Regulations Section 301.7701-3. Unless you are in a community property state, you cannot bypass the partnership layer or report this activity directly on your Form 1040.

Section 179 Special Allocation

While partnerships generally allow for special allocations of many tax items such as income and losses where a minority partner can be allocated the majority of losses, Section 179 comes with an important limitation. The IRS applies Section 179 caps at both the entity and individual partner levels, meaning partners cannot use a partnership to bypass their personal dollar, income or basis limitations. Boo, right?

Although Section 179 can technically be specially allocated, those allocations must meet substantial economic effect rules and cannot be used solely to shift deductions to members or partners who can best use them. As a result, many partnerships end up allocating Section 179 in proportion to ownership or economic interests, making it a less flexible planning tool.

In contrast, depreciation deductions including the current class favorite, bonus depreciation, flow through as ordinary losses and can be specially allocated, provided the allocation has substantial economic effect. This allows partnerships, particularly in real estate, to structure allocations that direct larger upfront deductions to partners with higher taxable income, while aligning with the underlying economic arrangement. Very common strategy within small syndicates.

Penny Perfect Balance Sheet

We mention this issue under the downsides of rentals in partnerships section, but it is true of any business entity tax return including C Corporations. Why? During preparation, WCG CPAs & Advisors always prepares a Schedule L which is fancy talk for a balance sheet. Why is that a downside? If the numbers aren’t tracked carefully, things get out of whack. There are two situations-

The first situation is the rental property purchase itself. Capital accounts need to be set up showing the down payment from each partner (member). These amounts are usually quite large, so it is easy to track the earnest money and cash required to close, who paid what, and blah blah blah.

Where it gets tricky is when someone pays for something outside of closing. How does this happen? Simple! You and your rental estate investment partner find a lovely property that is going to be an amazing short-term rental. Before a business entity such as an LLC is set up, and long before a business checking account is opened and seeded, you likely need to pay for an appraisal and the inspection, and this is done with personal cash.

As you will read later, acquisition costs and loan costs are part of the overall asset purchase and are listed on your fixed asset listings within the tax return. In full-on geek speak, we will debit two assets on the balance sheet- acquisition costs and loan costs, but we need a corresponding credit to liabilities or equity. It’s called a balance sheet for a reason, right?

Where are we going with all this? Your payment for the appraisal using personal funds will become part of your capital account as equity to correspond to the debit entry for loan costs that will be amortized.

Ok, neat. We haven’t moved on to the second situation quite yet- we are still on the first situation with another twist. Those silly advanced escrow funding amounts (not prepaids such as hazard or property insurance) are assets like a security deposit. It is technically your money being held by a fiduciary. More geek speak for you- you will bring cash to closing and this will be a credit to your capital account (equity). A part, albeit tiny, of the corresponding debit will be the escrow funding. Darn double-entry accounting and balance sheets.

Phew! You still with us?

The second situation is less nutty but can create a bunch of woes just the same. Most rental properties will show a tax loss, sure, but will also have a cash loss requiring the partners to inject cash into the business checking account. A capital call if you will, and as such this needs to be tracked so capital accounts can be properly credited.

Another version of this is when personal cash is used to directly pay for an expense. This happens frequently- for example, you use your personal credit card at Home Depot or Lowe’s if you prefer blue, but don’t think too much about how this expense was paid when it comes to tax return preparation. Now we have a business expense being paid with personal funds, which in itself is not the end of the world, but it does anger some tax gods when attempting to reconcile cash on the tax return’s balance sheet. Technically, this would be considered another increase to your capital account, a credit, to go along with the garbage disposal expense, a debit.

Wait! There’s more. At tax return preparation, we will need the ending cash in your business checking account plus the ending mortgage balances in an attempt to balance, well, your balance sheet. In addition, if you are personally responsible for the mortgage debt, and it is likely you are unless your loan to value is below 60%ish, this too adds to your basis and must be tracked alongside your capital account balances. More fun!

Mix and Match Rental Activities in One Partnership

To be fair, this is more of a headache for your tax professional but you should be aware just the same. Let’s go right to the extreme, shall we? We shall! Let’s say you and your brother-in-law have three rentals- a short-term that qualifies for the loophole, a long-term and a vacation home that everyone and their brother including in-laws and the occasional tenant use.

When the Form 1065 partnership tax return is prepared, all these activities will be reported on a K-1 for each owner. More accurately, all the rental activity and net profit or loss will be reported on Box 2 of the K-1. What are we getting at here?

You might see one big fat negative number in Box 2, but it has different tax implications and handling. A part of the loss can be deducted since it is the short-term rental with an average guest stay of 7 days or less with material participation. Fun! A part of the loss associated with the long-term rental might be deductible depending on the owner’s modified adjusted gross income.

The remaining part of the loss will be carried over as vacation home losses to be hopefully one day be used in a galaxy far far away. What makes vacation home losses even trickier is the bifurcation of operating expenses and depreciation which are tracked separately as unique carry overs. Yuck.

In a perfect world, you would have a separate business entity for each rental activity type (short-term, mid / long-term and vacation). However, this increases your tax return preparation and things don’t conveniently remain static (short-term one year, vacation the next).

Specific Vacation Homes Problems in Partnerships

There are two primary specific problems with vacation homes in partnerships. Here we go-

Generally, vacation homes should not be owned by a business entity for the considerations above. However, at times you need a formal agreement between two owners, and an entity such as an LLC provides this. For example, you and another family member want to own a magnet home together and occasionally rent it out- you need some governance or rules of the road if you will, and an Operating Agreement provides this. See our pure LLC holding company section for more information.

One of the biggest reasons to have a mixed-use rental property, or what the IRS would call personal use of a dwelling unit or vacation home, is to defray costs of ownership. Said in another way, a vacation home can be a nice split between current-day lifestyle enhancements and long-term wealth-building.

According to IRS Publication 527 Residential Rental Property–

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

14 days, or

10% of the total days it is rented to others at a fair rental price.

If you trip these wires, the IRS considers the rental property (dwelling unit) a home and your expenses and therefore rental property deductions are limited.

Specifically for partnerships, and as far as we can tell from the tax code and other resources, each owner (partner) does not get a fresh set of 14 days or 10% rented days. That’d be nice, right? Rather, if owner A uses the property for 10 days, and owner B uses it for 9 days, this will be 19 days total.

See our vacation home rules section for more information.

Material Participation in a Partnership

We are getting a tad ahead of ourselves discussing material participation at this point in our book. Please refer to our material participation rules section for a deeper discussion. Having said that, a little fair warning-

Many real estate investors utilize the 100 hours and more than anyone else material participation entry point or threshold. 100 hours is easy, and you just need to ensure the cleaner, as an individual, does not spend more hours than you. But what about your business partner? If your partner is your spouse, hours can be combined for material participation. However, if your partner is the brother-in-law mentioned above, this becomes problematic.

A literal reading of the tax code suggests that you and your business partner must each be over 100 hours but also that your hours are identical. Here is a snippet from Treasury Regulations 1.469-5T(a)(3)–

Let’s rewrite this, shall we-

(3) The individual participates in the activity for more than 100 hours and their participation is not less than any other individual (including individuals who are not owners);

If they are at 103, you need to be at 103. This way your time is not less than your business partner. At times tax professionals, including WCG CPAs & Advisors, will say, “100 hours and more than anyone else.” This is not wrong, but it is not precise either since if it were, then each of you at 103 hours would not qualify, right?

Another consideration- In all the material participation chatter, the 7th test, which is facts and circumstances, is often thought of as kryptonite. Don’t touch it. Don’t look at it. We disagree. Keep mind the underpinning of the material participation tests- they are bright lines to remove the need for a facts and circumstances based argument. “Hey, give us a credible and reasonable time log and we’ll check the box without further explanation.”

Yet, the facts and circumstances argument or defense remains very much available. It would be silly to think that if you had 103 hours, and your business partner had 107 hours, the IRS would consider your participation efforts to be not material. Having said that, if you have 103 hours and your co-owner had 210 hours, that might be viewed differently.

Also, you can think of it this way- material participation is a per human and per individual tax return (Form 1040) sort of thing, and you don’t file a Form 1040 tax return with your brother in-law. That’d be weird and likely illegal in most states. Thanksgiving would be super awkward.

By Jason Watson, CPA
Posted Sunday, August 31, 2025

There isn’t a good place for this, and we toss around these concepts in various places in our book. There are two reasons to invest into rental properties-

• Build Wealth, and
• Lifestyle Choice

We do not buy real estate and rental properties for the tax deduction- that is silly. The tax deduction tail does not wag the wealth-building dog. If we can do both, then swell, but the primary objective in life is to die with the most toys, right? Sure, a big tax deduction from a big accelerated depreciation deduction from a big cost seg study can be redeployed into building more wealth. Got it.

However, the minute you flip the narrative, and chase tax deductions, you will make a bad decision along the way. 100% guaranteed, or as the young kids say, “hundred.” That shiny new short-term rental will still be yours long after you reduce your high W-2 income in year 1. Make sure it is a good choice- can it rent? Can it rent for what you want? Is it going to be a nightmare to manage?

Another consideration is lifestyle choices. Do you buy a rental property today that is not as operationally lucrative so that in 20 years you can kick out the tenants or take it offline, and make it your second home? Sure. Solid strategy! Emotional purchases are not bad- not everything has to add up or have an ROI or IRR that blows your hair back. Just think about a nice sports car or luxury sedan- they don’t make sense financially, yet they seem to sell often. It is permitted, perhaps encouraged, to feed your non-financial appetite along the way to building wealth with real estate and rental properties. You can have both!

By Jason Watson, CPA
Posted Sunday, August 31, 2025

Here are some FAQs you might find helpful as a chapter summary for ownership arrangements with rental properties and real estate investments-

Why should I invest in rental properties?

The two main reasons are to build wealth and for lifestyle choices, not simply for tax deductions. Yes, tax deductions can lead to more cash which can lead to more wealth, but smart choice and good judgement still lead the way.

Are tax deductions the primary reason to buy real estate?

No, chasing tax deductions leads to bad decisions; wealth-building should be the main objective, with tax benefits as a bonus.

Can lifestyle goals influence rental property investments?

Yes, some investors buy properties with future personal use in mind, such as converting them into a second home, balancing financial and emotional goals. Buying something out of love is not necessarily bad.

Is rental property considered a business?

Yes. Rental property, when managed with a profit motive and regular effort, is considered a business under IRS Section 162, especially if you materially participate.

What are the main business entities used in real estate?
LLCs, partnerships, and C corporations are common. LLCs are favored for flexibility and liability protection, while C corps are rarely used due to double taxation (but are good in a debt reduction environment).

Is an S Corporation an entity?
No. S Corp is a tax election, not a legal entity. It’s usually applied to an LLC or corporation to reduce self-employment taxes on earned income. Rental income is not subject to self-employment taxes.

Is an LLC necessary for each rental property?
Not required, but recommended. It provides liability protection, organizational clarity, and easier ownership transfers. But there are costs, and potentially high ones in certain states.

What are the primary benefits of putting a rental property in an LLC?
An LLC provides liability separation, potential anonymity, structured wealth transfer through an Operating Agreement, and compartmentalization of finances—all of which help streamline ownership and reduce risk.

Can I avoid transfer taxes by selling my LLC interest instead of the property?
Possibly. In some jurisdictions, selling your interest in the LLC (instead of the property itself) may bypass transfer taxes, but it comes with complexity and may limit the buyer’s ability to reset depreciation.

Should I form a new LLC for each rental?
Often, yes. This improves liability segregation and simplifies ownership structures, especially with higher-risk or out-of-state properties.

Should I put my rental property in an S Corp?
Generally, no. S Corps aren’t ideal for holding appreciating assets like rentals due to issues with asset distribution and limited deduction options.

Do I need a partnership return for a rental owned with my spouse within an LLC?
It depends. In community property states, you may file jointly without a partnership return. Otherwise, a Form 1065 is often required.

Can a rental property in a partnership reduce audit risk?
Yes. Partnerships (Form 1065) have a lower audit rate than individual returns and offer clearer tracking of partner basis and losses.

Can a partnership help with estate planning?
Yes. Multi-member LLCs can simplify gifting, ownership transfer, and valuation discounts when used properly with an Operating Agreement.

Can I add my child as a partial owner?
Yes, but with care. It allows income shifting and gifting strategies, but be aware of potential tax and control implications.

What are the downsides of owning rentals in a partnership?
Higher tax return preparation costs, complexity, and state filing fees. Partnerships also require additional record-keeping for capital accounts and contributions.

Can you mix short-term, long-term, and vacation rentals in one partnership?
You can, but it complicates taxes. Each type has different rules for deductions and loss limitations, which can get tangled in a single return.

Do partnerships limit Section 179 deductions?
Yes. Partnerships can’t use Section 179 to create or increase a loss, unlike individuals reporting directly on a Schedule E.

Should I add my spouse as a co-owner in the LLC?
Only if necessary. It’s rarely needed for tax purposes unless for asset protection or succession planning.

What is the 100-hour material participation threshold in a partnership?
You must participate in the activity for more than 100 hours during the year, and your hours cannot be less than any other individual’s hours (including non-owners). This means it’s not simply “100 hours and more than anyone else” but matching or exceeding the top participant.

Can spouses combine hours for material participation?
Yes. If your partner is your spouse, you can combine hours to meet the material participation test. It is a common strategy and reduces the pressure on one person if you both paint a wall or repair the deck.

Do business partners like a brother-in-law share hours for material participation?
No. Each business partner must independently meet the material participation test since participation is determined per individual tax return when considering the K-1 activity from the partnership.

What’s a capital account in a partnership?
A capital account tracks each partner’s investment in the business, including cash contributions, allocated profits, and personal payments.

Do partnerships need a formal agreement?
Yes, ideally. An Operating Agreement outlines ownership percentages, income splits, and procedures for disputes or exits.

Can a rental LLC be owned by a trust?
Yes. A trust can own an LLC interest, providing probate avoidance, continuity, and asset control after death.

Can a rental property lose money and still benefit me tax-wise?
Yes. With sufficient basis and material participation, losses may offset other income especially in short-term rental loophole or real estate professional scenarios.

Is real estate a good tax shelter?
Yes, but the primary function of a rental property or real estate investment is to build wealth. Tax savings or tax efficiency is a distant third and is solidly behind lifestyle choices (where you buy a rental today that you later convert to a second home).

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here is a summary of the upsides and downsides of a partnership entity owning rental properties for your memory jog-

• Partnerships allow for low audit rates and a mechanical demonstration of basis, and therefore the ability to deduct losses is presented with math.

• Partnerships report rental property activities on a K-1 which is then reported on each partner’s individual tax return. Each expense category such as management fees and repairs (the annoyingly visible ones) are kept far away from your individual tax return.

• Section 179 expensing is problematic since it is limited at the partnership level, and cannot create a loss and therefore offset W-2 income directly like reporting rental activity on your individual tax return might be able to do.

• Balance sheets in partnerships, or any other business entity which files a separate tax return, create havoc between recording assets correctly, tracking outside cash, and overall capital account reconciliations.

• Mixing various rental activities such as short-term, mid to long-term and vacation home properties will make tracking loss limitations and other calculations intensive.

• Material participation needs to be carefully tracked and partly planned.

Sidebar: You and your rental property co-owner can report a split of the rental property activities on each individual tax return. However, if you present like a business with continuous and regular involvement with a profit motive, the IRS could deem this a partnership arrangement and therefore require a partnership tax return (Form 1065) to be filed. Silly rabbit, can’t have it both ways.

Don’t forget to read our buying out your real estate partner section for some important considerations.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Chapter 1 serves as a comprehensive introduction to how rental property ownership intersects with business strategy and tax planning. It begins by framing real estate investments not just as passive assets, but as active business ventures that should be managed with intent and structure. The chapter emphasizes the importance of choosing the correct business entity including single-member or multi-member LLC, partnership, C corporation, or S corporations. The decision is based on goals, risk tolerance, debt service, and tax situation including estate planning.

Each entity type is explained with pros and cons, focusing on liability protection, audit risk, and tax return complexity. For example, LLCs are praised for their flexibility and ease of ownership transfers, while S Corporations are discouraged for holding appreciating assets like rental properties. The chapter also addresses nuances in ownership when spouses or family members are involved, particularly in community property states. Yay, family members!

We also answer the common question of “Should I put my rental property in an LLC?” Answer is Yes, but there are some reasons it might not make sense.

Further, it explores advanced strategies such as using holding and operating company structures, mixing different rental types within entities, and preparing for succession or exit scenarios. Here we go!

By Jason Watson, CPA
Posted Sunday, May 25, 2025

WCG CPAs & Advisors encourages short-term rentals to be owned by partnerships (ie, a multi-member LLC). Why? For three reasons-

Three Big Reasons

First, the historical audit rate of partnerships (Form 1065) is 0.4%. Super low compared to individual tax returns (Form 1040) which might be 4% to 12% depending on your income levels. Why does this matter? When you have a big cost segregation depreciation plus your big startup expenses such as furniture and supplies, and you then have a big tax deduction against your big W-2 income because your passive losses are no longer limited with your big material participation, it raises some eyebrows. Any large tax deduction raises eyebrows. Cute, electronic AI eyebrows, but eyebrows, nonetheless.

Second, with a partnership tax return, we can mechanically show your capital contribution (at-risk money) including recourse loan debt. Why does this matter? Let’s say you invest $250,000 into a new business, and that business loses money. The IRS sees your “partner basis,” the $250,000, within your 1040 tax return, and suddenly the $100,000 first-year loss doesn’t seem so out-of-whack. A short-term rental is certainly a business activity; sure, you might not have a profit right away, but you will make money someday (otherwise you wouldn’t do it, right?).

Conversely, a rental property reported on Schedule E of your 1040 tax return does not present the same way. The mathematical support relative to the allowed rental loss and tax deduction is simply not presented but rather assumed.

Third, all rental activities, including short-term rental (STR) activities, within a partnership tax return are reported on Form 8825. This is another layer of cloaking within the 1065 tax return and allows your rental income and deductions to fly just a little closer to the ground as compared to Schedule E page 1 of your 1040 tax return. There are three degrees of separation… the 1040 to the K-1 to the 1065 to the 8825, all wrapped with nice basis information. Wow, we really geeked out there.

Other Benefits of Partnerships Owning Rental Properties

Also, there is an additional reduction in audit rate risk and tax footprint with states. If you have an income-producing asset in a taxing jurisdiction, such as a rental property, then you have a tax return filing obligation even if the rental activity yields a tax loss. Why? A taxing jurisdiction, and in this case, a state department of revenue, has the right to inspect your books and records to ensure your loss is truly a loss. However, if you file a partnership tax return for the taxing jurisdiction, and that results in a tax loss, it is unlikely you need to file an income tax return as a person in that jurisdiction as well. This reduces your personal tax footprint among multiple states.

Other minor benefits of having your rental property reported as a partnership include anonymity of the enterprise, orderly transfer of ownership within the LLC’s Operating Agreement (versus a trust or will), discounted gifting of interests to others such as your kids, and some enhanced protection with charging orders (super flimsy, but they still exist).

If you structure the partnership with Mom and Dad, you can create capital gains tax arbitrage through a step-up in basis. See our real estate investing with family partners section on page 26 for more information.

Launching a Partnership Entity

How do you create a partnership? If you are married, this is quite simple. You and your spouse would be members of a multi-member LLC. Not married? There are other options. You could have a sibling, parent or child who hold economic interests in the entity (LLC, for example). They would not hold equity interests, but the arrangement would be considered a partnership, and the rental activities would be reported on a partnership tax return (again, Form 8825 within Form 1065).

Of course, this second method might be more hassle than it is worth, but the first example, the spousal version, is easy. Don’t run off and get married just to make a partnership. That’s nutty.

Sidebar: Let’s talk briefly about the short-term rental (STR) loophole. If the average stay of your guests over the course of the tax year (only considering actual rented days) is 7 days or fewer and you materially participate in the activity (think business owner versus investor), then your rental activity is not deemed passive.

Taking this one step further, and since your investment in the rental property is considered at-risk, losses from this type of activity are not limited and may be deducted against other sources of income such as W-2, K-1 from an S Corp, investment income, etc. We dive deep into this in a later chapter on page 164.

You can also move your rental property into a business entity after it’s been in service. Let’s say you and another person buy a rental, a few years go by, and you would like some of these benefits of a formal entity. You could easily work with a title company and the mortgage lender to transfer (assign) title to the entity. Be careful, however- at times this simple little transfer can kick off transfer taxes and fees charged by local governments and homeowner associations.

—

Disadvantages of partnerships and multi-member LLCs owning rental properties include the additional tax return preparation fees and perhaps unnecessary state taxes such as California’s franchise tax and LLC fee which can be summarized as money-grabs or “pleasure to do business in our state” fees. You need to consider your exposure versus the cost of reducing your exposure and therefore subsequent risk.

Section 179 Surprises
There is also a problem with IRC Section 179 when using an entity such as a multi-member LLC taxed as a partnership to hold the rental property and report its activities. Generally, Section 179 expensing cannot create a loss in the business entity. This is in contrast to depreciation which may create a loss. As such, there are scenarios where using leveraging Section 179 expensing in an entity might be limited.

The instructions for Form 4562 Depreciation and Amortization, reads-

Partnerships. Enter the smaller of line 5 or the partnership’s total items of income and expense, described in section 702(a), from any trade or business the partnership actively conducted (other than credits, tax-exempt income, the section 179 expense deduction, and guaranteed payments under section 707(c)).

What does this mean? For partnership tax returns (Form 1065), you determine the profits of the business, and then add back various things including the deduction taken for Section 179 expense including guaranteed payments. See our section on accelerated depreciation and Section 179 expensing on page 287.

Penny Perfect Balance Sheet

We mention this issue under the downsides of rentals in partnerships section, but it is true of any business entity tax return including C Corporations. Why? During preparation, WCG CPAs & Advisors always prepares a Schedule L which is fancy talk for a balance sheet. Why is that a downside? If the numbers aren’t tracked carefully, things get out of whack. There are two situations-

The first situation is the rental property purchase itself. Capital accounts need to be set up showing the down payment from each partner (member). These amounts are usually quite large, so it is easy to track the earnest money and cash required to close, who paid what, and blah blah blah.

Where it gets tricky is when someone pays for something outside of closing. How does this happen? Simple! You and your rental estate investment partner find a lovely property that is going to be an amazing short-term rental. Before a business entity such as an LLC is set up, and long before a business checking account is opened and seeded, you likely need to pay for an appraisal and the inspection, and this is done with personal cash.

As you will read later, acquisition costs and loan costs are part of the overall asset purchase and are listed on your fixed asset listings within the tax return. In full-on geek speak, we will debit two assets on the balance sheet- acquisition costs and loan costs, but we need a corresponding credit to liabilities or equity. It’s called a balance sheet for a reason, right?

Where are we going with all this? Your payment for the appraisal using personal funds will become part of your capital account as equity to correspond to the debit entry for loan costs that will be amortized.

Ok, neat. We haven’t moved on to the second situation quite yet- we are still on the first situation with another twist. Those silly advanced escrow funding amounts (not prepaids such as hazard or property insurance) are assets like a security deposit. It is technically your money being held by a fiduciary. More geek speak for you- you will bring cash to closing and this will be a credit to your capital account (equity). A part, albeit tiny, of the corresponding debit will be the escrow funding. Darn double-entry accounting and balance sheets.

Phew! You still with us?

The second situation is less nutty but can create a bunch of woes just the same. Most rental properties will show a tax loss, sure, but will also have a cash loss requiring the partners to inject cash into the business checking account. A capital call if you will, and as such this needs to be tracked so capital accounts can be properly credited.

Another version of this is when personal cash is used to directly pay for an expense. This happens frequently- for example, you use your personal credit card at Home Depot or Lowe’s if you prefer blue, but don’t think too much about how this expense was paid when it comes to tax return preparation. Now we have a business expense being paid with personal funds, which in itself is not the end of the world, but it does anger some tax gods when attempting to reconcile cash on the tax return’s balance sheet. Technically, this would be considered another increase to your capital account, a credit, to go along with the garbage disposal expense, a debit.

Wait! There’s more. At tax return preparation, we will need the ending cash in your business checking account plus the ending mortgage balances in an attempt to balance, well, your balance sheet. In addition, if you are personally responsible for the mortgage debt, and it is likely you are unless your loan to value is below 60%ish, this too adds to your basis and must be tracked alongside your capital account balances. More fun!

Mix and Match Rental Activities in One Partnership

To be fair, this is more of a headache for your tax professional but you should be aware just the same. Let’s go right to the extreme, shall we? We shall! Let’s say you and your brother-in-law have three rentals- a short-term that qualifies for the loophole, a long-term and a vacation home that everyone and their brother including in-laws and the occasional tenant use.

When the Form 1065 partnership tax return is prepared, all these activities will be reported on a K-1 for each owner. More accurately, all the rental activity and net profit or loss will be reported on Box 2 of the K-1. What are we getting at here?

You might see one big fat negative number in Box 2, but it has different tax implications and handling. A part of the loss can be deducted since it is the short-term rental with an average guest stay of 7 days or less with material participation. Fun! A part of the loss associated with the long-term rental might be deductible depending on the owner’s modified adjusted gross income.

The remaining part of the loss will be carried over as vacation home losses to be hopefully one day be used in a galaxy far far away. What makes vacation home losses even trickier is the bifurcation of operating expenses and depreciation which are tracked separately as unique carry overs. Yuck.

In a perfect world, you would have a separate business entity for each rental activity type (short-term, mid / long-term and vacation). However, this increases your tax return preparation and things don’t conveniently remain static (short-term one year, vacation the next).

Specific Vacation Homes Problems in Partnerships

There are two primary specific problems with vacation homes in partnerships. Here we go-

Generally, vacation homes should not be owned by a business entity for the considerations above. However, at times you need a formal agreement between two owners, and an entity such as an LLC provides this. For example, you and another family member want to own a magnet home together and occasionally rent it out- you need some governance or rules of the road if you will, and an Operating Agreement provides this. See our pure LLC holding company section on page 32 for more information.

One of the biggest reasons to have a mixed-use rental property, or what the IRS would call personal use of a dwelling unit or vacation home, is to defray costs of ownership. Said in another way, a vacation home can be a nice split between current-day lifestyle enhancements and long-term wealth-building.

According to IRS Publication 527 Residential Rental Property-

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

14 days, or

10% of the total days it is rented to others at a fair rental price.

If you trip one of these wires, the IRS considers the rental property (dwelling unit) a home and your expenses and therefore rental property deductions are limited.

Specifically for partnerships, and as far as we can tell from the tax code and other resources, each owner (partner) does not get a fresh set of 14 days or 10% rented days. That’d be nice, right? Rather, if owner A uses the property for 10 days, and owner B uses it for 9 days, this will be 19 days total.

See our vacation home rules section on page 102 for more information.

Material Participation in a Partnership

We are getting a tad ahead of ourselves discussing material participation at this point in our book. Please refer to our material participation rules section on page 118 for a deeper discussion. Having said that, a little fair warning-

Many real estate investors utilize the 100 hours and more than anyone else material participation entry point or threshold. 100 hours is easy, and you just need to ensure the cleaner, as an individual, does not spend more hours than you. But what about your partner? If your partner is your spouse, hours can be combined for material participation. However, if your partner is the brother-in-law mentioned above, this becomes problematic.

A literal reading of the tax code suggests that you and your partner must each be over 100 hours but also that your hours are identical. If they are at 103, you need to be at 103. You can think of it this way- material participation is a per human and per individual tax return (Form 1040) sort of thing, and you don’t file a Form 1040 tax return with your brother in-law. That’d be weird and likely illegal in most states. Thanksgiving would be super awkward.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

There are several benefits of owning your rental property in an LLC as we’ve discussed throughout the chapter. Here is a summary-

• Separate checking account for compartmentalization. However, you could easily open another personal checking account for the same effect.

• Anonymity provided the state allows for displaying the registered agent only (many do, but many also list the “organizer” who is normally you, the person). If a state requirements additional ownership reporting beyond a registered agent, a multi-tiered or multi-entity arrangement can solve this such as a Wyoming LLC owning a Texas LLC, which we discuss in more detail.

• Orderly ownership (wealth) transfer baked into the Operating Agreement side-stepping Wills and Trusts. This is super efficient when a holding company LLC owns a gaggle of other LLCs that each own a rental.

• Division between the holding company and the operating company.

Additional Benefits of LLCs Owning Rental Properties

With a multi-member LLC you also get these fun things-

• Lower audit rates. Not that you’re trying to do anything nefarious, but who wants to defend their actions if avoidable?

• Mechanically show the basis in the rental property absorbing (cloaking) that big depreciation deduction from your even bigger cost segregation report.

• Rules of the road for all members (owners) of the rental property or real estate venture including deal structures.

• Exit strategies including divorce, death, valuation approaches, etc.

• Some, yet flimsy, protection with Charge Orders and other financial protections.

In the interest of fair play, here are the downsides with an LLC owning a rental-

• Additional tax return and the associated preparation fees in a multi-member LLC environment (unless you are in a community property state).

• Annual Secretary of State filings. Some states are cheap, some are insanely expensive.

• Franchise tax or some sort of LLC fee charged by a state’s Department of Revenue (which are separate from Secretary of State filings… they get to double their pleasure).

Another LLC Consideration

By having an LLC own the rental property, you might be able to avoid transfer taxes and fees. What are we getting at here? Many local jurisdictions, HOAs and other governing bodies impose a transfer tax or fee when the title of the real estate changes hands. What if the title never changes hands? Huh?

What if instead of selling the rental property itself, you sell your interest in the LLC or other business entity that hold the title? This might add some complexity or even risk for your buyer, but then again, some transfer taxes and fees are shared in a real estate transaction. As such, there is some motivation.

Sidebar: In most business transactions, buyers purchase the assets of the entity or operation versus buying the entity outright. This is for two primary purposes- buyers don’t want the historical risk that tags along with a business entity, and they usually want to reset the depreciation schedules including acceleration and Section 179 expensing.

The big downside to selling the LLC outright is the depreciation issue just mentioned. The buyer would need to continue with the same depreciation cadence even if the underlying asset (the rental property) has appreciated greatly. And No, there are rules preventing arbitrage where the new buyer buys into the entity as a co-owner, receives a step-up in basis to reset depreciable basis and clocks through an IRC Section 754 election, and then buys out the remaining interest in a bang-bang transaction.

The right circumstances would need to come together including the right people- we don’t see this often, but bring it up just the same.

By Jason Watson, CPA
Posted Saturday, September 7, 2024

The previous section was about holding companies versus operating companies, but this particular LLC holding company variant does not have any commercial activity. It is purely a holding company. While this might not be 100% germane to the rental property discussion, it certainly could be used for holding other real estate investments such as syndication interests. What are we talking about here?

Let’s say two people want to own an airplane which is way more fun than some real estate syndication. They could title it in their own names such as Buzz Aldrin and Amelia Earhart JTWROS. The fancy JTWROS is joint tenancy with rights of survivorship. This means that should Amelia die before Buzz, typically Buzz would absorb her interest in the airplane.

Time moves along, and Buzz and Amelia want to bring in Pete Mitchell as a third owner. They could add Maverick to the title because no one really knows who Pete Mitchell is, but this gets a bit cumbersome. If you add financing with personal loan guarantees to the mix, it could get messy if the bank wants to re-write the loan docs to add Pete… err… Maverick.

Rather, Buzz and Amelia would create a multi-member limited liability company (MMLLC) called The Little Red Bus LLC. This entity would hold title to the airplane but it would not have any commercial activity. The LLCs’s Operating Agreement would dictate how members could come and go, what happens if one member passes away, and other entity governance items. Therefore, when Pete Mitchell wants to be a part-owner, he would simply acquire member interest in the LLC. Title would not change since The Little Red Bus LLC owns the airplane, and Buzz, Amelia and Maverick own the LLC. Loan documents would not change, but perhaps an additional personal guarantee would be required.

LLCs are being used more and more in non-commercial or non-operating environments to make transfer of ownership super easy. We see this with boats, exotic car collections, art, investments, among other things. Also, since there is no commercial activity, a tax return would not be required. Yes, an EIN would be necessary for a business banking account, but that in itself does not trigger a tax return filing requirement.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We discuss this sporadically throughout the chapter in various ways. It is very easy to purchase a rental property with another person. You hold title as joints tenants with rights of survivorship (JTWROS), and report the allocated rental activity on Schedule E of your individual tax return (Form 1040). 50-50, 1/3 1/3 1/3. Easy.

Remember that marriage is easy to get into, hard to get out. A real-life case presented itself to WCG CPAs & Advisors where two couples bought a ski condo in Colorado as a short-term rental. One of the couples got divorced and moved to California. The Colorado couple would let anyone and their brother use the condo without paying rent. The California divorced couple would continuously inject cash to float bills. This went on for almost a decade. Nothing the California divorced couple do but smile and nod. Sure, they could have stopped injecting cash but then again, they were guarantors on the mortgage loan. Rock and a hard place sort of thing.

Eventually the Colorado couple divorced and were suddenly compelled to sell. Needless to say, no one exchanges Christmas cards.

This could have all been solved with a multi-member LLC with a beefy Operating Agreement. Even with your parents or sibling or someone who is close to you, formalizing the relationship with an LLC and Operating Agreement protects everyone in an agreed-upon (and ahead of time) way.

Specifically with parents, you are still able to get a step-up in basis upon their death for their portion. For example, you and Mom buy a rental property for $300,000. Mom passes away, and the property is worth $400,000. Your basis would end up being $150,000 plus $200,000 or $350,000. If the rental property was owned by an LLC which was in turn owned by you and Mom, an IRC Section 754 election might be required.

See Real Estate Investing With Family Partners for additional considerations. You won’t have to wait long… it’s next.

Another minor issue that happens from time to time with titles held as joint tenants, when the rental property is sold and a Form 1099-S is filed by the title company, they do one of three things-

• put all the proceeds on one person’s SSN,

• they file multiple 1099s with the full proceeds for each owner, or

• they accidentally do it correctly and split it.

The first two situations stink and can be resolved within the tax returns, but invite risk and headache. An LLC resolves this issue.

Regardless of LLC or not, another wrinkle exists when selling real estate in a state that is not your resident state. The title company is often required by law to withhold taxes (what we accountants call backup withholdings). How these withholdings are coded when submitted to the state can be problematic. One SSN? Everyone’s SSN? The entity’s EIN? Messy. The lesson here is to dig deep into the reporting when you sell a rental property.

At times you might want to hold title as tenants in common (TIC) where upon your death, your interest transfers to the remaining owner(s) for very narrow reasons. This is rare, however.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

This is one of the most common situations where you own two entities that conduct business between themselves. For example, you are a typical poor accounting firm with the usual high maintenance clients, and you feel that everything would be better if you also owned your own office building. You would create an LLC as the holding company which owns the building, and another LLC (and probably taxed as an S Corp) for the operating company.

This allows for some excellent ownership separation. For example, if you and your father-in-law own the building, he doesn’t have a stake in your accounting firm, and vise-versa (didn’t we just scare you with this idea, and now we are bringing it up as an example… we’re evil). You might also want to make one of your key employees a business partner in your operations, but he or she should not have a stake in the building. Chinese Wall. Can we use Chinese Wall as a separation analogy anymore? We likely offended someone.

Please keep in mind that rental properties including self-rentals are mostly wealth-building strategies and not tax reduction strategies. Yes, depreciation and perhaps even cost segregation can yield some accelerated tax savings, but even that is primarily a wealth-building move.

The holding company and operating company arrangement can also reduce self-employment taxes or payroll taxes since this conduit changes the color of money. Huh? As discussed in an earlier chapter, your accounting firm’s income is earned income, taxed both at the self-employment tax level (or payroll tax level) and the income tax level. However, you reduce this earned income by the amount of rental expense and that subsequent rental income on the other end is considered passive and only taxed at the income tax level (technically nonpassive since it is a self-rental under Section 469, but let’s not muddy the waters).

Beauty! You must have a lease and the rent must be market rates; usually a rent appraisal from an independent appraiser will suffice. The rent appraisal is also a good idea in the expansion of ownership. For example, Jason and Tina Watson own the building that WCG CPAs & Advisors leases. As WCG expands its ownership to other partners, the rent payment to Jason and Tina needs to be above reproach; ergo, a rent appraisal. This reduces office politics and hurt feelings. Maybe just office politics.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

As mentioned in other areas of this book, your family might benefit from adding children and / or parents to your entity. For example, you could have your children be 10% owners each. They in turn pay very little tax compared to you, and they can either gift the money back to you (good luck) or you can surrender and use this ownership method as a conduit to give them your money which is going to happen anyway but at a reduced tax effect. Imagine helping them pay for basic living expenses, college or savings using business dollars while reducing your overall taxes? Nice, for sure, but it takes some planning.

Step-Up in Basis Upon Passing

When your parents pass away, their assets such as stocks, primary residence and other investments such as real estate, receive what is called a step-up in basis to the fair market value upon death. IRC Section 1014 reads in part-

(a)In general
Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be—

(1) the fair market value of the property at the date of the decedent’s death,

Keep in mind that the word “property” does not mean only real property. It means all property such as cash, stocks, cars, etc.

For example, Mom and Dad buy a house for $300,000 and it is worth $750,000 upon their passing. You receive this property through normal inheritance, and your basis is $750,000. If you sell it for $750,000, and likely a bit less with concessions and selling expenses, you will not have a gain.

Sidebar: However, and we see this all the time, if Mom and Dad gift the house to you even one day before their passing, you absorb the original cost basis ($300,000 using the example above). Not good. WCG CPAs & Advisors recently had a client whose father quit claimed the house to his son about two months before passing. It cost the family unit, and specifically the son, over $270,000 in capital gains. All avoidable.

Ok, neat, how do you use this in a rental property environment? You, and Mom and Dad, create a business entity such as an LLC, where you are a 1% owner with Mom and Dad at 99%. This entity would be taxed as a partnership in most cases. You run the rental property, and with special allocation, you receive 100% of the profits or loss. No muss no fuss for Mom and Dad.

The Operating Agreement dictates that upon passing, Mom and Dad’s interest in the LLC transfers to you through normal inheritance. You would likely need a Will or a Trust as well to tidy all this up. An average estate planning attorney should be able to assist.

As such, some tax arbitrage is created. How? Using the same example above- you buy a rental property for $300,000, Mom and Dad pass away when it is worth $750,000, and you later sell it for $900,000. You would have a gain of 1% of $450,000 and 100% of $150,000 or about $154,500 (versus $600,000).

Sidebar: In states with community property laws, both halves of the community property receive a step-up in basis upon the death of one spouse. This too can be used in retirement and estate planning as well.

Downsides to the Gibberish Above

The step-up in basis upon a co-owner’s passing stuff above is overly simplified- there are some devils in the details. Perhaps even a gaggle of devils.

First, Mom and Dad probably don’t pass away at the same time. So, do you pick one parent over the other to be the majority owner? This becomes an awkward discussion explaining why you are picking one parent over the other in a “step-up when you pass” context.

Second, should both parents be owners and if one passes before the other, you might need an IRC Section 754 election for an intermediate step-up in basis. You would also need this should you and another member, such as a spouse, be owners alongside Mom and Dad.

Sidebar: This is straight from the IRS website on FAQs for 754 elections- “An IRC Section 754 election allows a partnership to adjust the basis of the property within a partnership under IRC Sections 734(b) and 743(b) when one of two triggering events occur: 1) a distribution of partnership property or 2) certain transfers of a partnership interest. These adjustments can only be made if the partnership has made an election under IRC Section 754.” There you go.

Third, is the juice worth the squeeze here? This is a long-term play- you would need to buy a property several years prior to the transfer upon death and therefore step-up in basis to garner as much tax-free benefit of the appreciation.

Fourth, if a partnership remains after Mom and Dad’s passing, and an IRC Section 754 election is not invoked, then only the entity itself is getting a step-up. In other words, the real estate property is not receiving the step-up in basis directly. Rather, Mom and Dad’s interest in the LLC is receiving the step-up in basis based on the underlying assets of the entity that have appreciated. You would need to sell the entity which holds title to the rental property, to enjoy the tax-free aspect of the appreciation and therefore gain. See our LLC benefits for rental properties section for more information.

Fifth, you might be able to achieve similar step-up in basis results from owning the property as joint tenants with rights of survivorship (JTWROS). While a formal entity arrangement is usually preferred dictating ownership percentages, rights to profits and losses and actions upon death, it is not necessarily required.

As you can see, there are several issues that need to be sorted, and planning is only as good as your crystal ball or your ability to plan for various contingencies.

Income Shifting

For example, they are 25 years old making $50,000 on their own. Your rental properties had net profits of $250,000. Because of exemptions and deductions, your child is in the 10% marginal tax rate whereas you are in the 22% marginal tax rate. Not a huge swing, but you get the idea.

Other examples include minor children. Yes, a minor can own shares in an S corporation or generally own interest in an LLC. However, given kiddie tax rates (even with the recent SECURE Act) this might not be beneficial since your child could be taxed at your rate. What if the minor child materially participates in the business activities? Huh?

There are seven tests for material participation, and the easiest one for your child to meet is 500 hours per year (or about 10 hours a week). The activity must also be regular, continuous and substantial (this is straight out of the ATG – Audit Techniques Guide from the IRS). There are other tests that are preferred when you need to claim material participation (such as for the short-term rental tax loophole) but they are not as easy for your child. See the WCG CPAs & Advisors blog for more details.

wcginc.com/blog

Back to the issues at hand. If you nail down the material participation with your minor children, they can earn income and be taxed at their own tax rate as opposed to your tax rate. Yes, they can gift the money back to you for your bar bill or make a contribution to their retirement accounts (unlikely with pure rental income, but you get the idea). We prefer the former naturally.

Wait! There’s more. You can still claim them as a dependent if you provide over half of their support. How expensive are kids? Really expensive! The word “support” is very interesting. Here is an example; your child could earn $20,000, and puts $15,000 into savings to one day buy a house. They also have $12,000 in living expenses. If you paid $6,001 of those expenses, you are providing over 50% of their support and the child can still be your dependent. Seems a bit silly, but it is good tax planning just the same.

Your Mom and Dad can qualify for this as well where you could siphon income and distributions off to Mom, and she will be taxed at her income tax rate. Also, if you own and operate an S Corp for those brokerage commissions, management fees, and fix and flips, you don’t have to pay a salary to shareholders who do not materially participate in the business activities (inactive shareholders).

Let’s recap the idea of children and parents being owners. The practical theory is that if you are going to provide $1,000 for your children or parents, it takes $1,300 or $1,400 in total cash assuming your tax rate is higher than theirs. Moreover, you could “gross up” the $1,000 to account for taxes at their rate and still come out ahead overall in cash (which is what we all care about).

Keep in mind that the juice might not be worth the squeeze. If you are going to deploy these tax strategies, another zero is probably needed.

Family Problems

Yuck but real. Thanksgiving becomes super awkward when the pressures of business or real estate ownership span family members including in-laws. A lot of discussion and even disagreements between business partners are absolutely necessary for successful business stewardship. But retreating to neutral corners is tough with the entire family watching.

Wait! There’s more. If you get divorced from your spouse, it is crummy and a bit messy. You own a business interest with your spouse’s sibling, and a bit messy becomes a real problem.

Imagine you owning a rental property with an in-law. You might not be able to exit gracefully; regardless of fault, your in-law is sitting on your ex-spouse’s side of the room and backing every play. You might not be able to buy him or her out either if the asset has appreciated substantially. Lovely, just lovely.

De Facto Partnership

If you own a rental property with another person, and you operate that rental as a business with regular and continuous involvement, the IRS could claim this arrangement is a partnership and require a Form 1065 partnership tax return to be filed. Here is the blurb from the IRS-

A partnership is the relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business.

As such, you need to be careful. You and another person own a rental. If it is a passive activity with a long-term tenant, then you can report the activity on your respective individual tax returns. If you are both hands-on with a short-term rental, or a gaggle of long-germ rentals, then perhaps this is a de facto partnership.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Should you immediately form an LLC with your spouse? No. Don’t you see enough of each other at the house? All kidding aside, there are two primary reasons for adding your spouse to the entity as an owner are-

• Leverage the minority owned small business benefits (usually with government contracts). This is getting less and less lucrative, and doesn’t apply to rental properties. There might be some other real estate investment opportunities.

• Asset protection through Charging Orders and the associated rules with multi-member LLCs (attorney stuff).

• Your spouse suggests it one lovely evening over dinner, and upon reflection of considerable collateral damage, you surrender. A solely owned entity such as an LLC or corporation is still a marital asset in most jurisdictions and as such will be part of any divorce action regardless (might not be the same in estate planning however since Operating Agreements might dictate).

We tricked you there into thinking there were only two primary reasons. Gotta have some fun with this material, right?!

Back to the question of adding your spouse to the entity as an owner; please note how tax savings or other big “wow” things are not listed. In other words, adding your spouse as an owner only has two super narrow bands of benefits.

Two Options

If you and your partner are married, and want to become the next power couple, you have two basic options-

• Report your rental property activities on your individual tax returns as if no entity exists, or

• Form an entity, treat the entity as a partnership and file accordingly on Form 8825 (like a Schedule E rental property form) within Form 1065 (the actual tax return).

How you arrive at these two options will vary depending on your state’s property laws. There are two types of states beyond red and blue; community property and common law property. Here is some gee whiz information. Community property laws stem from Spanish law whereas common law property states originate from the English law system. Therefore, it makes sense that most of the community property states are in the southwest portion of the United States plus the odd ducks up there in Wisconsin, Washington and Idaho.

Community property states dictate that the income is added into a “community” pot, and then divided equally between the joint taxpayers. Federal laws will usually follow the state laws in terms of income joining and splitting, with some exceptions here and there. On a jointly filed tax return this is moot, but if you need to file a separate tax return this gets complicated (separate tax returns are occasionally needed for second marriages or prenuptial agreements). But regardless of the taxation issues, there are also some procedural issues with business ownership.

Community Property State

Two people, married, in a community property state are not a partnership unless they elect to be treated as such. Electing to be treated as a partnership will complicate things from a tax preparation perspective, does not provide any added tax benefit, and forces you into one of two situations, which are both ultimately equal. You could prepare a partnership tax return and create separate K-1s for you and your spouse at 50% each, or prepare a partnership tax return and create a joint K-1.

Sidebar: We just said, “no added tax benefit.” This is technically true in the purest sense. However, reporting your rental property and real estate investment activities within a partnership tax return provides two big benefits (audit risk and tax basis tracking) that we discussed earlier Rental Properties in Partnerships.

Please recall that a K-1 is the byproduct of a pass-through entity (PTE) tax return which summarizes various business and rental activities that are later presented on the owners’ individual tax returns (Form 1040). Additionally, Box 1 on a K-1 is for ordinary business income, Box 2 is for net rental real estate income and Box 3 is for other net rental income.

What the heck is a joint K-1? Rare, Yes, but the K-1 would be issued to the primary taxpayer’s SSN but read “Bob and Sue Smith, JTWROS”. When your individual tax returns are prepared, this joint K-1 gets spread among both you and your spouse equally, and therefore the income might be taxed with additional, unnecessary Social Security taxes.

Don’t like that idea?

A husband and wife owning an LLC in a community property state can be considered one owner, or in the case of an LLC, one member and therefore becomes a disregarded entity as opposed to a partnership. The rental property and real estate investment activities are then reported on Schedule C or E of your Form 1040. However, if you properly prepare your individual tax returns, you will split the business activities equally between you and your spouse.

Sidebar: An individual tax return is a bit of a misnomer. It is synonymous with Form 1040, and may be filed as one person or two married people (married filing jointly). In both situations, the tax return is called an individual tax return. Many of us think of the word individual as numerical such as one or single. But in the case of tax returns, individual is better known as person or human. Furthermore, a married couple is considered one in so many walks of legal life, hence the singular use of individual in referencing a tax return.

Let’s run through these three tax return scenarios once more when a married couple own a business together in a community property state-

• Elect partnership with separate K-1s at 50% each, or

• Elect partnership with joint K-1, or

• Remain a disregarded entity (single member LLC) and evenly split activities on two Schedule Cs or Es (you and your spouse), and report them collectively on your individual tax returns (Form 1040).

All three of these scenarios are identical from an income tax perspective.

Common Law Property State

Similar to community property states, a husband and wife (or same-sex couples) living in a common law property state have two options- file a partnership tax return or elect to be a qualified joint venture.

Two major differences to note here right away; in common law property states, the presumption is that you and your spouse are a partnership. In community property states, the opposite is true. The presumption is that your business entity is essentially a qualified joint venture.

The other major difference is that in a common law property state, you can chop up the business activities based on a pro-rated basis of involvement / interest in the business. This might not be relevant for most real estate investors, but, and as an example, your husband supports your consulting business by handling the books; perhaps his involvement is only 15%. This is converse to community property states which generally divide things equally (whoever thought a marriage was a 50-50 relationship was fooled long ago, but here we are).

Some other details allowing married business partners to be a qualified joint venture include the following-

• You and your spouse are the only members (owners) of the joint venture, and

• You file a joint tax return (Form 1040), and

• You both materially participate in the business operations (which has legal IRS definitions attached to it such as number of hours and activities), and

• You are not operating the business (or rental property venture) as a limited liability company (what?!).

The last one is the deal breaker for most people. According to IRS rules, if you and your spouse operate a multi-member LLC, whereby each of you are members of the LLC, then you must file as a partnership using Form 1065 in common law property states. Most people are confused on this including attorneys and other CPAs. Don’t believe us? No worries, refer to these wonderful IRS resources-

wcginc.com/5401

There is a flimsy reason why a qualified joint venture for a husband-and-wife team might make sense over a partnership. A disregarded entity (single-member LLC) or a husband-and-wife team that elect to be a joint venture can theoretically have unlimited losses reported on Schedule C of your joint Form 1040 (assuming the money invested is at-risk).

This contrasts with a partnership where your losses cannot reduce a partner’s basis below zero. In other words, if you invest $5,000 in a partnership you can only lose $5,000. Without going into crazy detail, this is different than a partner’s capital account (for example, you inject property into the partnership that is worth $10,000 but you only paid $2,000 for it, your capital account will show $10,000 but your basis in only $2,000). Sorry for the diversion.

Having said all this, WCG still prefers to file partnership tax returns even for married couples in community property states since it allows us to track your capital accounts and other basis information. As mentioned elsewhere, this is a valuable presentation when deducting large rental property losses because of accelerated depreciation. Also, if you sell the business or get divorced or bring on a new partner, then this history is readily available. Otherwise, you must rebuild this information.

Additionally, the audit rate risk is much lower for partnership tax returns than individual tax returns. This does not mean you can be cavalier with your tax positions, but it certainly provides comfort in having a lower risk in defending them. We expand on this in a bit.

If a narrow reason exists, the qualified joint venture election can be made on Form 8832. Here is a quick summary table for married couple teams-

You might be saying to yourself, Yeah, but there must be some good reasons to add my spouse to the ownership. Here are some considerations.

Disadvantaged Business

Women are a protected class, and therefore might receive favorable government contracts or grants as small business owners. Same sex couples might see increased favorable treatment as well. Don’t forget about Veterans and other groups of people whose status might be leveraged.

There are several acronyms out there-

Yeah, okay, the last one was a joke. You should always explore these opportunities especially if you are engaging with governments. There are also businesses who will certify your entity as one of the above since there has been a lot of fraud lately. Shocking. Say it isn’t so!

Charging Orders

When you have a multi-member limited liability company, and there is a judgement against a member of the LLC, the creditor must obtain what is called a charging order from a court. Theoretically this forces the creditor to only receive distributions from the LLC rather than the LLC’s assets. Adding a spouse creates a multi-member LLC situation, but there are some caveats. A later chapter has more information on the concept of charging orders (spoiler alert: it is flimsy legal defense for owners who are married to each other).

Audit Rates

According to IRS data for the 2019 tax year (the most recent data set), 9.3 million partnership and S corporation tax returns combined (Forms 1065 and 1120S) were filed. Of those, 17,543 were audited for an audit rate of less than 0.2%. This further breaks down to 15,852 as a field audit (face to face at your place of business) and 1,691 as a correspondence audit (letters). The IRS is slow to compile and release this data, but we doubt the trend has shifted.

Of those audited by a field audit, 35% resulted in a no-change audit whereas correspondence audits resulted in a no-change audit 52% of the time. This is a blended rate, and digging deeper into the data reveals that partnerships generally result in a no-change audit about half of the time, whereas the same result for an S corporation happens about 33% of the time.

Audit rates for individual tax returns (Form 1040) for the 2019 tax year for adjusted gross income between $50,000 and $200,000 was 0.1%, whereas $200,000 through $1,000,000 was 0.4%. These rates increase to 0.6% and 1.0% respectively with Schedule C and Schedule E. Therefore, if you are in this second band of income range, a partnership or S corporation tax return will have half the IRS scrutiny as your individual tax return. To say half is a bit misleading, right? In practical terms, your audit rate risk goes from microscopic to tiny… both scenarios are favorable, but you get the general idea.

Ownership Transfer with Married Couple Teams

If you are concerned about ownership transfer in case of death, we suggest taking care of this issue within your estate planning. Transfer of assets between spouses during death is generally seamless in most states. Contact an estate planning attorney for more comprehensive analysis and advice.

If you are concerned about separation of property during divorce, our experience and observation show that a single owner will still be required to obtain a business valuation from an expert and the business becomes a marital asset. This becomes tricky in a rental property situation since you have income-producing assets but the assets themselves also have value. Generally, you cannot use both the asset approach and the income approach, and commonly the asset approach is the highest and best representation of the value. Having said that, in some commercial settings or severely depressed property values, the income approach is more representative of the value.

Business valuations for divorces sounds like fun, doesn’t it? A real hoot. WCG CPAs & Advisors is heavily involved in forensic accounting and business valuations, so if you need help let us know. Remember, the goal of any divorce is to ensure both parties are equally upset. No one should be high-fiving as they leave the courtroom.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

This will be a quick section. A disregarded entity is just that, disregarded for tax purposes. All the activities will be reported directly on your Form 1040 tax return as if the entity doesn’t exist. You will get this with single-member LLCs and multi-member LLCs between married couples in community property states should they elect as such.

A pass-through entity (PTE) has a separately prepared and filed tax return, but does not generally pay taxes at the federal level (there are some rules when C Corps elect to be taxed as S Corps). Rather, the activities are reported on a K-1 and that resulting information is pulled into your Form 1040 tax return on Schedule E Page 2, and other schedules and forms depending on the data reported. For example, capital gains, depreciation, interest income, among other things within the pass-through entity’s activities are considered separate items on a K-1. If interest income is earned within the PTE, this will be reported directly on Schedule B on your 1040.

PTEs and disregarded entities have two things in common. First, the ultimate handling of the tax effects and calculations are done on your Form 1040 tax returns. Second, the state might impose a franchise tax or some other related fee or tax on the entity; this is where a slight diversion occurs. PTEs will pay this state level tax directly within its state return, and disregarded entities will pay as part of the state tax return filed as a person.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We scattered little comments here and there about S Corps. Here is a quickie recap when it comes to rental properties and real estate investments owned by S corporations.

Generally, you do not want to have appreciating assets in an S corporation environment. Should you want to revoke S Corp election, or your election is deemed ineffective because of conflicting language in the Operating Agreement or side-pot deals with your business partners, assets are distributed to the shareholders at fair market value. This can create capital gains without cash, which is typically bad. Even in Canada (joking, Canadians are ok at math).

Also, keep in mind that the primary purpose of an S corporation election is to change the color of money. Earned income goes in which is normally taxed at both the self-employment tax and income tax levels. However, with an S Corp, only wages paid to the shareholder are subject to Social Security and Medicare taxes (self-employment taxes). As such, the lower the wages within the confines of reasonable shareholder salary the better from an overall tax perspective.

Next, rental income is usually passive income and therefore not subject to self-employment taxes which are also known as Social Security and Medicare taxes. Armed with those two concepts, you can see that an S Corp election is not necessary on rental income.

Entities taxed as an S Corp are still recommended for earned income which might come from brokerage commissions, management fees, and fix and flips. We mention this since real estate investors take all kinds of shapes and colors; some are pure rental property owners while others are involved in all sorts of investment madness.

Sidebar: S Corps are subject to hobby loss rules in a sense. In other words, if your S Corp loses money each year, the IRS might consider the activity a hobby or an activity not in pursuit of a profit. What are we talking about here? You have an S corporation that earns very little. You contribute additional paid in capital each year to create shareholder basis so you can deduct your automobile or other owner-friendly deductions. You create a tax loss, and since you have basis, you can deduct that loss on your individual (Form 1040) tax returns. Scam. Harsh? Not at all.

For more riveting information and a deep dive as they say into S Corporations and self-employment taxes, please see our book titled, Taxpayer’s Comprehensive Guide to LLCs and S Corps.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We have seen some real estate investors leverage the C corporation in similar fashion. They inject a bunch of cash into the entity, and then buy a gaggle of rental properties with cash and debt. Every spare dollar is used to pare down debt, and any taxable income (rental profits) is paid at 21%. Later they elect S Corp status on the entity, wait 5 years for the built-in gains (BIG) tax waiting period, and then sell the rental properties at individual long-term capital gains rates (plus depreciation recapture).

Can you still do that big cost segregation study with that big depreciation deduction? Yes. Does it have the same thrill? Not really if you are currently at a 37% marginal tax bracket with your personal income. In other words, the wow factor at 21% is not the same as 37%.

What makes matters worse is that your rental property is likely to have losses in the early years, and to pile on with accelerated depreciation does nothing for you. In other words, to accelerate deprecation to accelerate your cash flow by lowering taxes requires taxable income. This is usually in the form of W-2 wages found on an individual tax return (Form 1040) and not a corporate tax return (Form 1120).

Of course, this assumes passive activity loss limits are being bypassed with real estate professional status or short-term rental loophole. Conversely, if you cannot accelerate your cash flow and you want to plow excess cash back into debt reduction, the C corporation might work.

Do you miss out on the Section 199A qualified business income deduction (QBID)? Yes. But consider the highest tax bracket of 37% multiplied by 20% yields a 7.4% delta which is still less than the delta between 37% individual tax rates and 21% C corporation tax rates. You might not benefit from the QBID if you are in the 37% marginal tax bracket given the secondary testing starting at the 32% marginal tax bracket.

Stessa and some other real estate CPAs say Never to rentals and C Corps. WCG CPAs & Advisors disagree. However, super duper careful tax planning is necessary. A crystal ball helps too.

There might be an issue with accumulated earnings tax (AET), but don’t get too hung up on that since depreciation will reduce earnings (tax loss or tax neutrality, but cash “gain”). Then later on down the line you elect S Corp tax status on this C Corp and you have the best of both worlds… reduced income tax for some time, and then avoided double taxation as you start pulling out excess cash from rental income or from property sales.

As you look to other investors and players in your real estate property purchase, don’t forget the golden rule where the person who has the gold makes the rules. Said differently, if an investor or venture capitalist wants to put their money with you, and they will only do so under a C corporation regime, you are stuck between a rock and a hard place.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

The big knock on C Corps is that they might be tax inefficient. Wyoming was the first state allowing LLCs in 1970, but most states did not follow suit until the 1990’s. Therefore, if you wanted to avoid double taxation you had to first create a C corporation and then elect S corporation taxation.

Thanks to current tax law changes, corporations now enjoy a 21% income tax rate. But… not all that glitters is gold. Dividends are then taxable to you up to 23.8% (which is 15% to 20% capital gains plus 3.8% of Medicare surtax potentially). Therefore, your effective tax rate for using a C Corp as your entity choice ranges from 36% to 44.8% where the top individual rate of an S Corp shareholder is 37%. This is the double taxation part.

Not all is bad with C Corporations.

C corporations generally enjoy better financial liability protection and have much easier transfer of ownership. Taxes are paid at the corporate level to the IRS and states (either through an income tax or a business tax) on Form 1120. Notice the subtle difference; 1120 and 1120S.

Because of the relatively low tax rate as compared to the highest individual tax rate, C Corps can leverage debt reduction at a cheaper rate. How? You buy a piece of equipment with a loan. A portion of the loan payment is principal and is basically paid with after-tax dollars since the interest portion is deducted. Said in another way, you make $1,000 in profits and use $1,000 of it as accelerated debt reduction. You will still pay tax on the $1,000. Yuck.

So, the question becomes, if you must pay taxes on the $1,000, would you rather do it at 21% than 37%? We’ll give you a minute to decide with an optional chin rub. Again, this is predicated on smart budgeting and using excess cash to pare down debt versus that European cruise you’ve been eyeing.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

General Partnerships (GP) have unlimited liability exposure whereas Limited Liability Partnerships (LLP) have, as the name would suggest, limited exposure for the limited partners. There is also the limited liability limited partnership (LLLP or triple “L” P) which extends liability protection to the general partner as well. Remember, this is financial exposure not necessarily other perils such as tort liability. More about that later.

We won’t discuss these entity types much either since they have fallen out of favor lately. Many attorneys are now creating two classes of members within a MMLLC to mimic the different groups that a true partnership would create. So, it walks and smells like an LLP but it is actually a MMLLC, without the burden of complication and cumbersome ordering rules. For example, “A Members” are the old-school version of General Partners, and “B Members” are the equivalent of Limited Partners. Most of the attorneys we work with don’t create partnerships anymore, including family limited partnerships (FLPs), opting instead for the use of MMLLCs.

Throughout this book we might refer to members as partners. More often than not we are referring to a member of a multi-member LLC. While partner and member are technically different, and the entity type will ultimately decide member or partner, these words are often interchanged by business owners; we are doing our best to reverse the trend.

What gets really obnoxious is shareholder and member. A C corporation has shareholders. An LLC has members. A C Corp taxed as an S Corp has shareholders (that one is easy). But an LLC taxed as an S Corp has members and shareholders. From an entity perspective, we use members. From a tax return perspective, we use shareholders. Why? Historically before the existence of LLCs, an S corporation’s underlying entity was predominantly a C corporation.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Once you take your single-member LLC and add a member, you are now a multi-member LLC (MMLLC). Boom! Instant increased complexity. The IRS will now call you a partnership since you have more than one member and as a result you will file a Form 1065 Partnership Tax Return.

As we discuss later, however, there are distinct advantages to having your rental properties owned by an entity (e.g., MMLLC) taxed as a partnership such as lower audit rate risk and mechanically showing tax basis in your losses. We will explain more in a bit.

However, you are technically not a partnership, but rather you are a multi-member LLC with an Operating Agreement as opposed to a partnership with a Partnership Agreement. Adding your spouse typically counts as a MMLLC unless you are in a community property state which is explained a bit later in this chapter (it’s underwhelming but important).

Therefore, we must be technically sound on the nomenclature. Smart people rarely interchange the Bears and professional football team, yet many people often interchange 401k and IRA, and multi-member LLC and partnership. This is incorrect. A MMLLC might be taxed as a partnership, but the underlying entity is a limited liability company which has different rules and state statutes as compared to partnerships. Governance, and the rules encompassing that, is different than taxation. Easy to confuse the two.

MMLLCs are similar to sole proprietorships and SMLLCs in terms of income and self-employment taxes, but enjoy a bit more financial protection through the concept of Charging Orders (more on that later in this chapter as well). Transfer of ownership is the same as a SMLLC since you have a member interest that can be gifted, sold, inherited, painted purple, etc. However, most MMLLCs will have an Operating Agreement governing the transaction of each members’ interest.

Operating Agreements will also define the sharing of expenses and income. For example, you could be an angel investor at 20% injection but demand 50% of the income (or losses in rental property environments). Expanding this concept further, a partnership tax return (Form 1065) generated from a MMLLC will have three “allocations” for each member; allocation of capital, profits and losses. Commonly profits and losses are tied together. Again, you could have a 20% allocation of capital and a 50% allocation of profits and losses.

Operating Agreements also become critical when the entity has value- issues like death, divorce, incapacitation, required distributions, dispute resolution and exit strategies must be handled within the agreement. Perhaps a separate Buy-Sell Agreement is required (usually funded with life insurance- we can help navigate on this).

You and your real estate partner are besties today, sure, but our job at WCG is to protect your future with a malleable arrangement that endures and provides for a graceful exit. All without unnecessary complication.

Partnerships and those mimicking partnerships (MMLLC) commonly require a separate partnership tax return on Form 1065 (with an allowed exception for those living in community property states), which creates K-1s for each member or partner.

This might be your first brush with the term K-1. A K-1 is similar to a W-2 since it reports income and other items for each member, partner, shareholder, owner or beneficiary. It is coded to tell the IRS how the business activities should be treated.

A K-1 is generated by an entity since the entity is passing along the income tax obligation to the K-1 recipient (hence the concept pass-through entity, or PTE for TLA lovers). Additionally, Box 1 on a K-1 is for ordinary business income, Box 2 is for net rental real estate income and Box 3 is for other net rental income.

There are three basic sources for a K-1, and the source dictates how the income and other items on the K-1 are handled on your individual tax return (Form 1040). Here they are-

• Partnerships (Form 1065)

• S Corporations (Form 1120S)

• Estates and Trusts (Form 1041)

All of these are PTEs with the exception of a trust, which might or might not a be pass-through depending on the purpose of the trust. A K-1 is usually filed electronically as a part of the tax return that is generating the K-1. As such, it is preferred to prepare and file your individual income tax return after the PTE’s tax return is filed.

We say preferred because it is not absolutely required. However, you run two risks; the first risk is that the K-1 information could change once the PTE’s tax return is finalized. The second risk is that too much time lapses between the tax returns, and the IRS sends a tax notice based on a database mismatch (mismatch between what you report and what the IRS has… like a bad game of Go Fish… “Do you have a K-1?” “Go fish.”).

A K-1 from a Form 1065 Partnership Tax Return and a K-1 from a Form 1120S S Corporation Tax Return are scarily similar. We could hold two K-1s about three feet from your face and you couldn’t tell the difference- heck, we couldn’t either. What makes matters worse, is that they both are reported on Page 2 of your Schedule E, and ultimately on line 5 on Schedule 1 of your Form 1040.

But here is the crux of the matter, so please pay attention- one is generally subjected to self-employment taxes and the other is not simply based on which form created it (1065 versus 1120S). Read that again! There is another subtle difference. Expenses associated with K-1 income from Form 1065 are deducted immediately on Page 2 of Schedule E as Unreimbursed Partnership Expenses (UPE) while shareholders of S corporations do not have a place to deduct shareholder expenses.

Sidebar (we love these by the way): In McLauchlan v. Commissioner, Tax Court Memo 2011-289, the court states-

The parties dispute whether the expenses at issue are deductible as unreimbursed partnership expenses. Generally, a partner may not directly deduct the expenses of the partnership on his or her individual returns, even if the expenses were incurred by the partner in furtherance of partnership business. Cropland Chem. Corp. v. Commissioner, 75 T.C. 288, 295 (1980), aff’d. without published opinion 665 F.2d 1050 (7th Cir. 1981). An exception applies, however, when there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense. Id.; Klein v. Commissioner, 25 T.C. 1045, 1052 (1956).

Having said that, most S corporation shareholders are also considered employees so they would deduct unreimbursed employee business expenses on Form 2106 and Schedule A. With the passage of the Tax Cuts and Jobs Act of 2017, Form 2106 expenses are no longer deductible on Schedule A.

As mentioned earlier, S corporations are usually seen with brokerage sales and commissions, management fees, and fix and flips. Your real estate investor who only does rental properties, including short-term rentals and commercial properties, will not use an S Corp to report these activities.

Please refer to our companion book, Taxpayer’s Comprehensive Guide to LLCs and S Corps, about how to reimburse shareholders through an Accountable Plan for expenses incurred on behalf of the S Corp.

As a reminder, entities being taxed as a partnership or S Corp do not pay federal tax- the partners or the members of a MMLLC pay income taxes as individuals (again, hence the pass-through nature). But note the word federal. States can do a lot of crazy things, and there is a whole chapter in our other book about the 185 reasons not to elect S corporation taxation that touches on state related issues such as franchise taxes and obscene corporate taxes including what some call the “pleasure to do business in our state” tax.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Single-member limited liability companies (what we abbreviate as SMLLC) are treated the same way as a sole proprietorship since in the eyes of most taxing agencies SMLLCs are considered a disregarded entity. Just as the name suggests, the entity is disregarded for tax purposes and all rental activities are reported on Schedule C or E with your Form 1040.

The disregarded entity stands in contrast to the pass-through entity (PTE) which are usually partnerships and S corporations.

While the IRS disregards the general SMLLC, several states have a separate form or filing. California uses Form 568. New York uses Form IT-204 LL. Texas has an annual franchise tax filing on Form 05-102 (even with their recent changes in reporting requirements, the public information report is still required). We can keep going but you get the idea.

Therefore, SMLLC equals sole proprietor from a federal income taxation perspective and most states. However, keep in mind that a SMLLC enjoys some distinct benefits over a sole proprietor such as liability protection, anonymity and improved transfer of ownership through its Operating Agreement.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Having said all this, in some cases a sole proprietorship is preferred. For example, in California, there is an $800 annual franchise tax. Also, be wary of annual Secretary of State filing fees. Nevada is $350. Massachusetts is massive at $500. These are annual fees for just having an LLC. The “pleasure to have an LLC in our state” fee, if you will. Other states vary between $100 to $250, and a few remain free after the initial filing fee like Texas.

As such the question becomes, how much protection or benefits am I receiving for the additional costs of having an LLC? The answer is situational of course, and WCG CPAs & Advisors can help (we mentioned the shameless self-promotion bit earlier, right?).

By Jason Watson, CPA
Posted Saturday, August 3, 2024

There are three basic small business entities with variations within. The three basic entities are-

• Limited Liability Company (LLC), the crowd favorite.

• Limited Liability Partnership (LLP) Limited Liability Limited Partnership (LLLP or triple “L” P as the cool kids say), or the legacy dinosaur General Partnership (GP).

• C Corporation (for profit), and the Personal Service Corp.

While not important for most real estate investors, there is an additional entity subtype with the “Professional” prefix. Some states require certain professionals, such as doctors, attorneys, accountants and engineers, to be a Professional LLC (the PLLC) or a Professional Corporation (the PC). Since you don’t see too many LLPs these days, you don’t see too many PLLPs either.

Two notables are missing from the list. First, sole proprietors are not an entity nor is the variant or close cousin of “Doing Business As” (DBA). If you wake up and want to sell used copiers, you can, right now, without any formalized structure. It is not smart, but certainly permissible. At times sole proprietors are interchanged with single-member limited liability companies (SMLLC) since the IRS and most states consider a SMLLC to be a disregarded entity for taxation. Both a sole proprietorship and a SMLLC will end up on Schedule C of your Form 1040. However, they are truly different in several underlying ways.

Also note how an S corporation is not listed. It is not an entity. It is a taxation election. The underlying entity must be one of the above, and usually it is an LLC (either single-member or multi-member) for the ease of formation including documentation.

Spoiler Alert: It is not advisable to use an S Corp election on an entity that owns appreciating assets such as rental properties. We’ll explain why later. We see S Corps used for brokerage sales / real estate commissions including management fees, and fix and flips primarily.

Let’s chat about each of these entities in turn. Here we go…

By Jason Watson, CPA
Posted Saturday, August 3, 2024

A lot of this chapter’s material is in reference to general business ventures. However, we consider rental property investments and other real estate activities to be a business in the purest sense. Why?

Let’s back up a bit since some real estate investments are not necessarily a business venture in themselves, but the decision to invest has a profit motive. We’ll casually define three buckets-

True Passive Real Estate

Investors might purchase tranches or interests in a real estate syndicate or entity. This is not just real estate investment trusts (REITS) but rather private groups that offer a piece of the pie through partial ownership. You send money, and they send reports plus an annual K-1 for your individual tax returns (Form 1040). You have no control, you do not actively participate in decisions, and at times you don’t have the ability to divest or exit without severe redemption penalties or discounts.

We talk more about these from a tax planning perspective, but for now know that these types of investments can be leveraged to offset other passive income and therefore they become a part of the overall business venture mindset. In other words, while real estate syndicates can exist in isolation within your portfolio, they can also be a smart business decision when coupled with other real estate investments.

Passive by Tax Law, Business by Mind

This bucket is your general rental property investment where you are running the venture like a business. Keep the property occupied. Try to push up rent. Keep expenses low. All the things a business owner does, but for various reasons that we will get into later, the activity is deemed passive yet rises to level of IRC Section 162. We define Section 162 later in a few moments.

Real Estate as a Straight-up Business

The low hanging fruit in this bucket are brokerage commissions, management fees, and fix and flip activities. Simple.

The next real estate investment that is deemed a straight-up business is a rental property where you materially participate in the activity (as defined by nutty IRS tax code), and you are either-

• a real estate professional (REPS) in doing so or

• the property qualifies as a short-term rental (STR) with average guest stays of 7 days or less, or

• both.

We will discuss material participation in nauseating detail in another chapter. However, if we take another step back and see what the IRS is suggesting with its material participation rules, we will find that it is simply trying to draw bright lines to determine if your real estate activities are investments or businesses.

Here are considerations to have a business-like mindset to your real estate investments regardless of the buckets above-

• The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts over time. The Supreme Court has interpreted “trade or business” for purposes of IRC Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit. We would argue that rentals and general real estate investments fall under this auspice otherwise you wouldn’t do it. Sure, we all want that short-term tax loss to offset other income, but ultimately you want to make money.

• Running your rental property or other real estate investments like a business whether they are short-term rentals, syndicates, fix and flips, etc. helps provide a basic profit vision to the overall venture including day to day decision-making.

• IRC Section 199A offers an additional tax deduction for rental properties with taxable income provided they “rise to the level of Section 162.”

So, as you read through this chapter and others, please wrap your rental property and real estate investment mindsight with that of a business owner.