Rental Partnerships

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

• Audit exposure. Partnership tax returns historically have been examined less often than high-income individual tax returns, and reporting the rental activity through a Form 1065 moves the detailed rental activity onto the partnership tax return rather than presenting all of it directly on Schedule E of your individual tax return. When a big cost segregation deduction plus big startup expenses plus the short-term rental loophole create a big loss against your big W-2 income, it raises eyebrows. Cute, electronic AI eyebrows, but eyebrows, nonetheless.
• Basis ingredients on display. A partnership tax return shows each partner’s tax-basis capital account and share of partnership liabilities on the K-1. Those are major ingredients in determining outside basis, so invest $250,000, report a $100,000 first-year loss, and the tax return presents much more of the mathematical support for that loss than Schedule E does. However, the K-1 capital account is not the same thing as outside basis, and each partner remains responsible for tracking their own basis.
• Another layer. Rental real estate inside a partnership is generally reported on Form 8825, which sits inside the Form 1065, which feeds the K-1, which lands on your 1040. Interestingly, the current Form 8825 instructions specifically include “vacation or short-term rental” as a property type. That is a good reminder that an STR can be excluded from the definition of a “rental activity” under IRC Section 469 yet still be reported as rental real estate for tax return purposes. If substantial services turn the operation into a trade or business activity for reporting purposes, however, it belongs elsewhere on the Form 1065. Three degrees of separation, all wrapped with nice tax information. Wow, we really geeked out there.

What Are the Real Audit Rates?

Published IRS audit rates for individual tax returns are low. For tax year 2021, the most recent year outside the normal three-year assessment period in the IRS’s 2025 Data Book, the IRS reported roughly 0.6% for income between $500,000 and $1 million, 0.9% for $1 million to $5 million, and 6.6% above $10 million, with partnership tax returns around 0.1%. Several of the high-income audit rates are noticeably lower than the comparable 2019 figures, although the $500,000 to $1 million band remained about the same.

Those averages can mislead business owners and real estate investors. A tax return with Schedule C activity, rentals, big losses, cost segregation or passive activity issues gives an examiner far more to look at than a W-2 tax return at the same income. The IRS does not publish a multiplier for adding a rental, so nobody can tell you your odds precisely.

The takeaway: income matters, but complexity matters too. Putting legitimate business activity into a partnership or S corporation moves some of that complexity off your individual tax return, although the entity itself can still be examined, and the IRS has made partnership enforcement a stated priority.

Other Benefits of Rental Partnerships

A partnership can also simplify your personal state tax footprint. Real estate almost always gives the entity a tax connection to the state where the property sits, but whether each nonresident partner must also file an individual tax return during a loss year depends on that state’s filing thresholds and rules. Many states also decouple from federal depreciation, so your state depreciation, state loss and state loss carryover can all differ from the federal numbers and must be tracked separately. This is a likely scenario during cost segregation and bonus depreciation, and from that point on, your state history will be forever different than your federal history.

If the partnership files the required state tax return and reports a loss, an individual partner might not have a separate nonresident filing requirement in that state for that year. Other states still require the individual tax return, or handle the issue through withholding, composite tax returns or pass-through entity taxes. Either way, someone needs to track the state attributes for the year the property turns a profit or sells.

Other minor benefits include-

• Anonymity of the enterprise
• Orderly transfer of ownership through the LLC’s Operating Agreement (versus a trust or will)
• Potential valuation discounts when gifting minority or nonmarketable interests to others, such as your kids, generally supported by a qualified business valuation
• Some enhanced protection with charging orders (super flimsy, but they still exist)

Downsides of Rentals in Partnerships

Partnerships are not all sunshine. Downsides include-

• Extra tax return preparation fees, plus state taxes that may be unnecessary, such as California’s franchise tax and LLC fee (the “pleasure to do business in our state” money-grabs).
• Section 179 can get trapped. It is limited by the partnership’s business income and again at each partner’s level, unlike bonus depreciation, which flows through more freely.
• The balance sheet has to be penny perfect. Every capital contribution, capital call and personal credit card swipe at Home Depot needs to land in someone’s capital account.
• Mixing a short-term rental, a long-term rental and a vacation home in one partnership adds reporting complexity because each can have different passive activity and loss rules. While the face of the K-1 can show an aggregate number, the partnership must provide activity-level information on attached statements when the activities are treated separately for passive activity purposes.
• Personal use days on a vacation home are combined across all partners, not 14 days each.
• Material participation can get harder with a partner who is not your spouse. If you are relying on the popular 100-hour test, you must participate for more than 100 hours and at least as much as every other individual. Your spouse’s hours are combined with yours, but an unrelated partner’s hours are not.

Weigh your exposure against the cost of reducing it. Sounds easy, right?

How Do You Create a Rental Partnership?

If you are married, this is quite simple. You and your spouse are members of a multi-member LLC. In a community property state you can also choose to be treated as a disregarded entity under Rev. Proc. 2002-69, which is the opposite of what you want here, so you would still want to prepare and file a partnership tax return on Form 1065.

Not married? You need a real partner, such as a sibling, parent or child, who owns a real interest and shares in the economics of the venture. A 1% interest is not automatically fake simply because it is small, but a 1% interest handed to your kid only on paper to manufacture a partnership is the kind of arrangement the IRS can attack. The family partnership rules under IRC Section 704(e) and decades of case law ask whether the ownership is real. Does the family member actually own the interest, bear the economics, receive distributions and have the rights associated with ownership? Don’t run off and get married just to make a partnership either. That’s nutty.

Sidebar: What is the short-term rental loophole? If the average guest stay at your rental is seven days or less, the property is not a “rental activity” under the passive activity rules (Treas. Reg. 1.469-1T(e)(3)(ii)(A)). Clear that hurdle, then meet one of the material participation tests above (usually more than 100 hours and more than anyone else, including your cleaners), and the losses become non-passive and can offset W-2 wages without qualifying as a real estate professional. The details and traps are in our rental book, I Just Got a Rental, What Do I Do?, and at wcginc.com/str.