Benefits of Rental Property In Partnership Entities

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.

 

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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?

Activity	Deducted?
Short-Term Rental Loss	Yes
Long-Term Rental Loss	Limited Based on Income
Vacation Home	Limited, Carried Over

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.