Real Estate Investing With Family Partners

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

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.

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.