Rental Property In Partnership Entities

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

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

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).

Downsides on partnerships 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.

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.

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 into 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.