How to split income/expenses for rental properties with multiple owners?

[magiklamp]

Father owned four single family home rental properties as his sole and separate property. Father died intestate and as a result the property needed to be distributed as follows:

1/2 to surviving spouse

1/2 divided evenly among three children

Between the date of death and until the distribution of property was completed, the estate filed fiduciary returns, passing the income and the tax liabilities through to the beneficiaries according to the distribution schedule mentioned above. 

In July 2020 title was transferred to surviving spouse and children to hold as tenants in common. ALL income/expenses (including mortgage payments, more details below) related to the rentals flows through one bank account. The remaining profit will be periodically distributed from that account to each owner, according to the owner's ownership interest. As far as I know this should keep the taxes simple: each owner will multiply the total rent and the total of each expense by his percentage of ownership and enter that amount on his Schedule E.

A few questions:

1.  There is one owner (out of the four) who does 99% of the management, and all owners are in agreement that that one owner's share of income should be greater than his share of ownership. Instead of each owner receiving income and reporting income/expenses according to their ownership percentage, can they instead (collectively) come up with an alternative way to divide it? For example: surviving spouse = 48%, child 1= 22%, child 2 = 15%, child 3 = 15%.

1(b)  Presumably, depreciation must be allocated according to ownership interest no matter what?

2.  There is currently a mortgage on one of the properties. The loan is still in the name of the decedent. I've called the lender numerous times to try to get them to change it into the surviving spouse's name, but they don't seem interested. On the one hand, we like that arrangement, since that loan doesn't appear as a debt on the surviving spouse's credit report. But I wonder if the 1098 mortgage interest statement being issued in the decedent's name and SSN poses any issues. Currently, just like with all other expenses, on Sched E Line 12 each owner enters a fraction of the total interest paid that is equal to his ownership interest. Any issues there? What if the surviving spouse manages to officially assume the loan in her name? In any case , will the IRS really give us a hard time if they find out we're splitting up those interest deductions?

3.  Does anything change if the three children retitle their interest as joint tenants (instead of the current tenants in common)?

Edited 10/06/2020 to reflect the fact that property was transferred from Estate to Beneficiaries in 2020, and that the previously outlined tax plans for the family were but an assumption of what would be proper for tax year 2020.

[Anonymous]

seek professional help. My opinion is that you have a partnership that requires filing form 1065 which for 2019 was due 3/15/2020.  now being about 7 months late with 4 partners, the late filing penalty is now over $5,000. 

from IRS form 1065 instructions

Partnership
A partnership is the relationship between two or more persons who join to carry on a trade or business, with each person contributing money, property, labor, or skill and each expecting to share in the profits and losses of the business whether or not a formal partnership agreement is made.
The term “partnership” includes a limited partnership, syndicate, group, pool, joint venture, or other unincorporated organization, through or by which any business, financial operation, or venture is carried on, that isn't, within the meaning of regulations under section 7701, a corporation, trust, estate, or sole proprietorship

[Carl]

I did not read the entire post. But I read enough to realize you need professional help for at least the first year of dealing with this yourselves.

A 1065 Partnership return needs to be filed for 2019. The partnership return was due March 15, 2020 (there was "NO" extension for this, like their was for 1040 personal returns). The late fee is $200 per member for each month late. So your late filing penalty is already a few thousand dollars. So get professional help yesterday, if not sooner and clean this up and get things current.

[magiklamp]

Thanks. I've edited my original post to reflect the fact that property was transferred from Estate to Beneficiaries in 2020, and that the previously outlined tax plans for the family were but an assumption of what would be proper for tax year 2020.

Re: your opinion that we have a partnership: Does this apply even while (for now) we split income/expenses strictly according to ownership interest as recorded in the county records?

In the event that we do wish to split income/expenses differently, should we change the way we hold title to the property from tenancy in common to holding as a partnership?

[Anonymous]

ok seek pro help before the end of this year. because there are multiple owners of multiple properties with a least on actively if not materially participating I think there is still the need for a 1065 and since of your unusual situation this is not a do-it-yourself project.  my opinion would be that the special allocation to the partner managing the property would be a guaranteed payment (they are performing services)   so the net other income is split based on your ownership %'s. that guaranteed payment for managing the properties would be subject to self-employment tax.

the pro can evaluate the situation better because they can talk to you and ask whatever questions they want.  they could even disagree on the need for a partnership return.  It's their professional advice that you will be paying for.

if the IRS were to determine that you fail to file a partnership return the penalty is currently, based on the number of owners about $10,000 per year for each year. there could be other penalties for willful failure to comply with the tax laws.  

[Carl]

I've edited my original post to reflect the fact that property was transferred from Estate to Beneficiaries in 2020, and that the previously outlined tax plans for the family were but an assumption of what would be proper for tax year 2020.

Thats good. At least you don't have to deal with the $200 per month, per owner late filing fee. But do be aware that the partnership return is due March 15th every year. One day late, and the late filing penalty applies.

Re: your opinion that we have a partnership: Does this apply even while (for now) we split income/expenses strictly according to ownership interest as recorded in the county records?

Yes, and really it's more of a "strongly urged suggetion" and not an opinion per-se. Without a partnership, each partner runs a high risk of finding themselves in a tax hell in the future. I won't even get started on the other potential legal issues that could arise *outside* of taxes.

In the event that we do wish to split income/expenses differently, should we change the way we hold title to the property from tenancy in common to holding as a partnership?

I'm not a legal professional by any stretch of the imagination. Laws differ state to state, and sometimes even county to county. That's why you *need* to seek legal advice in your locale from a qualified, certified and licensed tax professional, as well as a real estate professional.  But consider this.

There are currently four owners of the property. Without a partnership that means each one of you has to report your share of income/expenses on page 1 of the SCH E of each of your individual tax returns. None of you have 100% ownership so a mistake on any one of the four SCH E's will throw things "out of balance" with the IRS, which could possibly result in all of your being audited. A partnership negates that possibility quite significantly.

Then there's the question of cooperation. What happens when one partner gets tired of dealing with it and stops paying their share of the expenses? What legal right does any other partner have to cut off their income from the property? Remember, in the eyes of the law two wrongs don't make a right.

Worse yet, what happens if one of the partner's is killed in an automobile accident tomorrow? More than likely his surviving widow will inherit their percentage of ownership. What if the window can't stand one of you? They can literally drive your rental business into the ground.

What if that parnter was divorced and his three kids inherit equal shares of his share of the property? Now you have 6 partners. What if one of those kids is underage and still a minor?

I can go on forever writing a multi-volume encyclopedia on all the "possibilities" here. This is why you folks need to set up a formal, legal partnership. It's not just to make taxes simpler. It will also make your lives simpler. With a partnership, the partnership agreement outlines, covers and deals with the ramifications of all possible scenarios that you can think of that my apply to "this" "specific" "partnership". To set up the partnership I suggest the use of a business lawyer that is well versed and hopefully experienced with partnerships. This will not cost you an arm and a leg either. Besides, any expenses incurred in the partnership setup process can be paid by the partnership anyway.

I'm urging you to "please" seek legal advice and get things set up not only for tax purposes, but also for the family as a whole. Money is the number one thing that can and usually will tear a family apart, and that split will be unrepairable, even at the funeral where regrets get you nothing.

With a partnership, only ONE IRS form 1065 partnership return is filed with the IRS each year. A K-1 is issued to each partner showing their share of the income and expenses. Each partner enters the K-1 data into their personal 1040 tax return, and they're done. Also makes things simpler with splitting the proceeds when the property is sold, not to mention that the partnership agreement already addresses what happens if a partner "wants out", or a partner can no longer participate for valid reasons (such as death, or long term hospitalization).

[magiklamp]

@Carl , thanks for the thoughtful post. 

I will seek professional help from a CPA specializing in real estate, assuming that is the best professional to consult. For now just trying to educate myself so that I can make the most of my time/money spent on professional consultations. 

I'd be interested to know what you all have to say about the following sentence from IRS Publication 541 under the section titled Organizations Classified as Partnerships:

However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

As far as I can tell, we currently co-own property that we maintain and rent; we do not provide services to the tenants.

Also a question on "primary state" where our Partnership would "conduct business": We all live in CA but all the rental property is in ID. Which state is the primary state where we conduct business? (This is a question asked by Turbotax Business software when I choose to file a Partnership return).

[Carl]

However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

That does not in any way, mean you can't treat it like a partnership, and it does not prevent you from creating a partnership. Your reasons for creating a partnership is not "ONLY" for tax purposes to make the tax reporting simpler. That tax front is but a very small part of this - but an important one.

we do not provide services to the tenants.

So what? There is no requirement for a partnership to provide any services at all. Nothing says you "MUST" provide services.

For example, if you and I decide to create a partnership to buy raw land, sit on it for year and then sell it when it's value increases so we can make a profit on the sale, we can do that.As land becomes available at a price we're willing to pay, we start buying it up. Pure raw land with no structures on it at all.  Then after holding it for a minimum of one year, we sell it - hopefully for a profit.

It's physically impossible for us to provide "services" to anyone, because "anyone" isn't utilizing the property for "anything". You and I own it and per our partnership agreement the land just "sits there" for a year and then we sell it. It's still a partnership and there's nothing that says we can't do it that way. (Though personally, I"d prefer at a minimum to form a multi-member LLC for such a venture if it will be more than a one-time thing.)

For you folks, the only thing that will be in the partnership is rental property. Therefore the only income produced by the partnership will be passive income and nothing else. (unless the members decide they want to expand the partnership to include other types of income.)

[M-MTax]

Also a question on "primary state" where our Partnership would "conduct business":

That's up to you and the other 'partners' but if you're all in CA and the partnership is based there then the state would be CA and you would also have ID sourced income because the rental is located in ID.