Question about depreciation recapture after selling HALF of my rental property

[REquestion]

Hi, I'm stumped on this one:  I sold 1/2 of my investment property to my friend in Dec 2020.  I have a small capital gain as the property was purchased in July 2018 and appreciated slightly over the past 2.5 years.

How do I recapture the depreciation?  Do I just split the amount of depreciation already taken since I only sold half of the property at this time?  Or do I simply pay taxes on the capital gain for tax year 2020 and then recapture the depreciation taken after the entire property is sold?  My partner and I agreed to hold the property and continue to use it as a rental for at least 2 years.  Who knows when we will sell... could be in 2 years, 5 years, 20 years, etc.  It depends on the rental market and our own personal circumstances in the future.

Can anyone help?  I looked at the IRS publications but couldn't determine the answer.

[M-MTax]

Your partner? Did the two of you establish a partnership for this rental? It sounds like you didn't sell half the rental to the friend but that you contributed the whole rental property to a partnership and the friend contributed half the value of the property in cash. If that's what happened you'll be filing a partnership return but you don't have to report a sale because you received cash in exchange for a partnership interest, which is still an ongoing enterprise. You need legal and professional tax advice no matter what.

[REquestion]

Hi and thanks for the response.  I used the word "partner" only in the sense that we are now "partners" in this investment property.  We hired an attorney to draft up a sales agreement between us as individuals.  No partnership per se was created.  We both file individual tax returns.  As such, I am stumped as if I need to recapture any or all of the depreciation already taken when I have only sold 1/2 of the property in Dec 2020.

[REquestion]

Oh - one more thing to add.  The property is not paid off yet.  Friend and I are in the process of refinancing and it is about to close.  I had $90K in equity in the property and friend paid me $45K for 1/2 of the equity and we are now both responsible for 1/2 of the mortgage.  At closing (in about 1 week or so), he will be added to title.  We will share everything equally - any costs (prop tax, maintenance, etc) as well as share any profits equally from the rental proceeds.  I thought we could still file individually and just list 1/2 of any expenses, losses, rental income on our own individual tax returns?  Do we really have to form a partnership and file a joint return?  The cost of doing so will probably exceed any nominal profit we earn on the property which is only approx $100 month cash flow positive at this point after mortgage, property tax, HOA fees and property management fees are deducted from rent.  At this point, it actually loses money on a tax return after you take depreciation into consideration).

[Critter-3]

Run run run to a local tax professional because you do do have a partnership and must file the partnership return before the personal returns are filed. Sorry your attorney friend did not advise you correctly.

[Carl]

After reading through this thread I am of the opinion you and your friend now have a legal partnership.

I used the word "partner" only in the sense that we are now "partners" in this investment property.

.....which further supports my opinion that you now have a legal partnership in every sense of the word, any way you look at it. Now it's not like you learn this stuff through osmosis. But the fact is, you need to seek the services of a tax professional yesterday, if not sooner. Here's the scoop, and what I'm confident any tax pro will tell you.

You now have a legally established partnership.

Friend and I are in the process of refinancing and it is about to close

That statement changes my "opinion" to what I would interpret as an undeniable legal fact. Especially if both of you will be listed on the deed "AND" the mortgage.

Basically, (assuming the change, minus the refi) if this occurred in 2020 you need to file a "final" SCH E with your personal return.

Then you will need to complete an IRS Form 1065 Partnership Return for the newly established partnership. The property will then be transferred to the partnership return "as is".

The partnership will then issue each owner a K-1 which they will need in order to complete their personal 1040 tax return.  This can be done with TurboTax, but it's very detail intensive and I highly recommend professional help for this, in the first year the partnership was established - which I understand to be in 2020.

Please get processional help. If you have no experience with this and screw it up attempting this on your own, rest assured that all the fines, penalties and back taxes you will "BOTH" be assessed will make the cost of professional help seem like a pittance in comparison.

[REquestion]

Thank you all so much for your help.  Am I (hopefully) correct in assuming that since the sale did not occur until 12/20/2020, that I am okay to "run" to a tax professional now, before filing my 2020 tax return?  I did not have to establish a partnership PRIOR to completing the sale, did I?  That is the only part I am unsure of.

If I am missing anything else, please of course, feel free to enlighten me.

[Critter-3]

The partnership  needs an EIN starting with the sale which really was not a sale as others have mentioned and you need to get that number ASAP so the partnership return for 2020 can be filed by 3/15/21 ...  you also need to set up the books correctly to reflect the transfer of a property and the inflow of cash to the partnership.  The ill fated sale also needs to be addressed on your personal return since you have a 1099-S issued.  Seek local professional assistance sooner than later. 

[REquestion]

I will definitely seek tax advice first thing tomorrow morning.  I googled partnership formation and stumbled on the IRS publication regarding partnerships and their formation.  I understood in theory what has been kindly explained by everyone above.  

That being said, here is a cut & paste of what the IRS says (and it makes it sound as though my particular "partnership" can be excluded and is unnecessary?)  The red highlighted words are my doing:

Exclusion from Partnership Rules

Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes.  All the partners must agree to make the choice and must be able to figure out their own taxable income without figuring the partnership's income.  

Investment partnership:

An investing partnership can be excluded in the participants in the joint purchase, retention, sale or exchange of property meet all the following requirements.

• They own the property as co-owners.

• They reserve the right separately to take or dispose of their shares of any property acquired or retained.

• They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. Each separate participant can delegate authority to purchase, sell, or exchange his or her share of the investment property for the time being for his or her account, but not for a period of more than a year.

Food for thought... am I misinterpreting what the IRS is saying?

Thanks for reading and sharing

[Carl]

Been there. Done That. Got the T-Shirt. 🙂

I'm telling you right now from personal first hand experience that matches your situation *EXACTLY*. A partnership is the absolute best way to go. Anything else, and you'll be dealing with this crap every single year. Then when one owner runs, the other owner is left holding the bag for *EVERYTHING* on the legal *AND* tax fronts.

[REquestion]

Ok, I don't want the IRS t-shirt 😥!  Partnership is the way to go!  Many many thanks for all the great advice.  Much appreciated 🙂

[AmeliesUncle]

I disagree with the others.  As you pointed out, mere co-ownership of a rental property (that does not rise to the level of a "trade or business"), is not a Partnership.  I suppose maybe it can be, but does not need to be.  To me, filing as a Partnership adds unnecessary complication.  However, I do recommend getting EVERYTHING in writing, to protect you both.  Going to a business attorney may be helpful with that.  It needs to be detailed, including what is to happen if one of you want out, if one of you dies, if one of you want to sell only their share to a third party, etc.

In answer to your question, you divide everything in relation to your "asset" in half.

Create a new "asset" for depreciation.  Enter HALF of everything; the Basis, the land, the prior depreciation.  Use the original "placed in service" date.

Do it again.  You now have two new "half" asset.  Then go through one of them and say it was sold.

Delete the original 'full' asset.

[M-MTax]

Yep, I agree with AmeliesUncle on this one because as was said "mere co-ownership is not a partnership" by only the status of co-ownership. The problem is you then have to enter this as a sale of half of your rental property which involves capital gain and depreciation recapture and you wouldn't have to do that if you treated this deal as a contribution to a partnership. 

[AmeliesUncle]

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@M-MTax wrote:

you wouldn't have to do that if you treated this deal as a contribution to a partnership. 

---

It has already been sold, so it is too late to contribute the entire property to a Partnership.  So there is a reportable taxable gain.

[REquestion]

Thank you AmeliesUncle and MartinMarks1919.  I did discuss with my accountant today and he was also of the opinion that we could be co-owners and not a partnership.  My friend has his own accountant, so he will ask his accountant on Monday (she is off work recuperating from Covid until Mon).  If she agrees partnership is not necessary, then I think we will probably go that route.  If there is any doubt, we will then do the partnership.

We did see an attorney who drew up an agreement between us that clearly outlines all terms, including how title will be held, how the property will be used (rental only) and the right of first refusal to each other prior to putting on the open market.  We have agreed in the agreement to use it as a rental for at least 2 yrs and then either party can request to sell their share after that time.  I believe we covered all contingencies within the agreement, as the attorney was used to guide us through it.

I do not mind paying capital gains for tax year 2020 (minimal as the equity and thus the capital gain was halved, plus due to job loss my income was very low for 2020).  And also do not mind recapturing half of the depreciation taken so far (also not that much since I originally purchased in July 2018).

Thanks again to everyone who is/has helped me through this.  It sounds as if there are 2 ways to approach it.