Real Estate Investing With Family Partners

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.