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How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

We have been renting out a second home (which is in our names - wife and mine) since 2015 and have reported rental income on Schedule E. The lease was also in our names. In June 2018, we started an LLC, and the lease now has the LLC as the landlord. The LLC has a separate business bank account to manage and track income and expenses related to rental property. How should we report the income and expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder? 

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7 Replies

How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

Is this a multi-member LLC and if so are you planning on filing a 1120S, and 1065, a 1120 return for the LLC?
Carl
Level 15

How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

Highly recommended reading. Pay particular attention to the last section, "Additional Information for Rental Property Owners."

Sole Proprietorship – This is a business with one owner, and only own owner. There are no other investors or share holders. This type of business is considered a “disregarded entity” by the IRS. All income and expenses for the business are reported  on SCH C as a physical part of the owner’s personal tax return. Again, a sole proprietorship has only own owner. Depending on what state the business is in, registration is not required at the state level. But it may be required at the county, town, or other level of government below the state. For example, your county may require you to register and obtain a county issued Occupational License, which authorizes you to conduct business only within the jurisdiction of the authority that issued the Occupational License. This is most often required when the county, city or other authority below the state taxes personal income or imposes a tangible property tax on business assets utilized to produce business income.

Single Member LLC - This is a business with one owner, and only own owner. There are no other investors or share holders. This type of business is considered a “disregarded entity” by the IRS. All income and expenses for the business are reported  on SCH C as a physical part of the owner’s personal tax return. Again, a single member LLC has only own owner. This type of business is required to be registered at the state level, weather that state taxes personal income or not.  Additionally, this type of business may also be required to obtain an Occupational License for the county(s), city(s) or other more localized jurisdictions within that state, in which the business will be operating in.

Multi-Member LLC – This is a business with more than one owner.  It’s also the exact same as a Partnership (for tax purposes) This type of business also has to register at the state level, and may also be required to obtain an Occupational License from more localized jurisdictions within the state, in which that business will operate.  This type of business will file its own physically separate tax return with the IRS (and state if applicable) referred to as a Partnership Return, on IRS Form 1065. When completing the 1065 (using TurboTax) the business will issue each individual owner a K-1 reporting the income (or loss) of each owner. Each owner will use this K-1 to complete their personal return. So an owner can’t even start their personal return, until after the 1065 Partnership Return has been complete, filed, and all K-1’s issued to all owners.

In the community property states of Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico, and Wisconsin if you have a multi-member LLC where there are only two owners, those two owners are legally married to each other, and those two owners will be filing a joint 1040 tax return, they have the option of splitting all business income and expenses down the middle and each partner reporting their share of the business income/expenses on a separate SCH C for each tax filer on the joint return. That means your joint 1040 return will have two SCH C’s included with it – one for each owner. But this can present its own problems in the event of divorce, separation. The issues can become even more compounded upon the death of one of the owners. If that deceased owner’s will does not pass all assets to the surviving partner, then that surviving partner can find themselves in a tax hell, not to mention the problems that can arise with the “new” owner or owners.

LLC “Like an S-Corp” – For tax purposes only (and I reiterate: FOR TAX PURPOSES ONLY!!!!!) one can elect to have the IRS treat their single member LLC or multi-member LLC “like an S-Corp” ****FOR TAX PURPOSES ONLY!!!!!****  This means your business is treated like and considered to be a physically separate taxable entity. This is accomplished by filing IRS Form 8332 – Entity Classification Election. This allows you to act as if your single member LLC or multi-member LLC is an S-Corp. But understand that if you want the IRS to treat your LLC like an S-Corp, then the business “must” act like an S-Corp, and follow all the laws, rules and regulations required of an S-Corp by whichever state your LLC is registered in. All business income and expenses is reported on IRS Form 1120-S – Income Tax Return For An S-Corporation. The S-Corp will then issue each owner, investor and/or shareholder a K-1 which they will need before they can even start their personal tax return.  Unlike a single member LLC which is considered a disregarded entity for tax purposes, an LLC that has filed form 8332 – Entity Classification Election  “is” considered and treated like a separately taxable entity.

S-Corp – This type of business is registered at the state level and must conform to the laws, rules, regulations and ordinances of that state which apply to an S-Corp. All business income and expenses is reported on IRS Form 1120-S – Income Tax Return For An S-Corp.  The S-Corp will then issue each owner, investor and/or shareholder a K-1 which they will need before they can even start their personal tax return.  Unlike an LLC which is considered a disregarded entity for tax purposes, an S-Corp  “is” a separately taxable entity, and therefore files its own physically separate tax return and issues K-1’s to all owners, officers, investors and shareholders.

C-Corp - This type of business is registered at the state level and must conform to the laws, rules, regulations and ordinances of that state which apply to a C-Corp. All business income and expenses is reported on IRS Form 1120 – Income Tax Return For A C-Corp.  The C-Corp will then issue each owner, investor and/or shareholder a K-1 which they will need before they can even start their personal tax return.  A C-Corp  “is” a separately taxable entity, and therefore files its own physically separate tax return and issues K-1’s to all owners, officers, investors and shareholders.

Additional Information For Rental Property Owners

Occasionally a rental property owner will be “convinced” they need to put their rental property into an LLC (be it single owner or multi-owner LLC) as a means of protecting themselves and their personal assets from legal litigation should they ever be sued by a tenant. The property owner is told the LLC gives them and their personal assets a “veil of protection” from any legal litigation that may arise as the result of legal actions perpetrated by a rental tenant. Nothing could be farther from the truth.  If you check court records (even in your local area) you’ll probably find numerous cases where a tenant sued their landlord and the LLC provided practically no protection of the property owner’s assets. That “veil of protection” supposedly offered by an LLC is so thin, even a new first time lawyer has no problem piercing that veil and attacking the personal assets of the property owner on behalf of the tenant. There are other problems and issues with this too.

In order to legally transfer ownership of rental property to an LLC, the owner must have the permission of the mortgage holder. No lender in their right mind will give this permission either. Even if you think you can refinance the property or “sell” it to your LLC, unless your LLC has the cash on hand to pay for it in full, your LLC will never qualify for the mortgage loan. The lender doesn’t want to risk your LLC going under (by filing bankruptcy for example), and they lose money because of it. So I’m confident in telling you, that’s not going to happen.

When you create an LLC for your rental property, it’s generally understood that business income gets reported on SCH C as a part of your personal tax return. However, a SCH C business produces “earned” income, and a rental property produces “passive” income. What’s the difference?

Earned income is income which you have to do out and “do something” in order to earn it. This income is subject to regular income tax, and also an additional 12.6% self-employment tax. The SE tax is basically the employer side of your social security and Medicare. But rental income is not “earned” income, and therefore is not reported on SCH C. So if you create an LLC for your rental property, then absolutely nothing concerning that rental property will be reported on SCH C. Not one penny of rental income and not one penny of rental expenses.

Rental income is “passive”. That’s because all you do with rental property on a recurring basis is just “sit there” and collect the rent every month. You are not “doing anything” to “earn” it on a recurring basis. That’s why rental income is reported on SCH E. Rental income is subject to regular tax, but is NOT subject to the additional self-employment tax. This means that rental income DOES NOT COUNT for your social security account or Medicare contributions.

SO if you create an LLC for your rental property, there are two things that will NOT happen.
 
- You will not be able to “legally” transfer ownership of the property from you, to the LLC unless you have a really dumb lender.
 - You will not report one penny of rental income or one penny of rental expense on SCH C.

So in the end, you will be filing a zero income/expense SCH C with your personal tax return.

Now let’s say you decide to file the 8832 to treat your LLC like an S-Corp, and then you transfer ownership of the property to your LLC. You can and will report your rental income on SCH E as a part of the 1120-S Corporate Return, and you will also report the K-1 on SCH E as a part of your personal tax return. But keep in mind that this is for ***TAX PURPOSES ONLY!!!****. So if a tenant sues you, I seriously doubt the courts will recognize your S-Corp, and I seriously doubt the court will recognize the S-Corp as a physically separate owner of the property. Remember, that 8832 Entity Classification Election is for “TAX PURPOSES ONY”. It has no weight at all for any and all other legal purposes – such as you being sued by a tenant.

SO if you want to do this (and it still makes no financial sense) then form an actual S-Corp and transfer ownership of the property to the S-Corp. More than likely the lender won’t allow the transfer. But you can sell the property to the S-Corp if the S-Corp can qualify for a mortgage loan.  Overall though, it’s still financially dumb to do this. Here’s why I say that.

When you move out of your primary residence and convert it to residential rental real estate, you have to convert your homeowner’s insurance policy to a rental dwelling policy. Or if you buy the real estate as rental property outright, then you have to obtain a rental dwelling policy at that time.  A rental dwelling policy will, at a minimum, include $300,000 of liability coverage. For most that will suffice. But if the property is in certain areas of the country you may want more liability coverage. I have three rentals myself and have a total of $1,000,000 of liability on each. It cost me less than an additional $100 a year on the insurance for each property. So for me, it’s worth it. It’s also significantly cheaper not only in money, but in time spent dealing with corporate taxes and all that other additional paperwork crap.

One mistake I see quite often is that when an owner converts their primary residence or 2nd home to rental property, and they fail to update their insurance policy. This can bite when you have a claim. If the property is insured as your primary residence, but you are using it as rental property (which is other than it’s insured use) don’t be surprised when the insurance company denies your claim, and you can’t find any lawyers that will take your case.  If it’s a case of you being sued by a tenant, then to be honest and put it bluntly, you’re screwed.

 

 

 


How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

@Carl many thanks for your extremely detailed answer. You gave me a lot to think about and certainly clarified some of the misconceptions. Reading through your posts, it appears that in order to lease the property as an LLC, the title and ownership MUST be transferred to the LLC. Noted that lenders are highly unlikely to accept this (makes sense). It feels then, that the best course of action for us is to keep it simple as we had it (owners renting out the second home) and recording income/expenses on the 1040-sch e. Once again, this was extremely helpful - and I really hope that others considering LLC for rental properties read through these nuances.
Carl
Level 15

How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

You'd probably not be surprised by how many people are convinced by a financial planner to do this and put a rental into a simple LLC. One has to remember that financial planners are in business to make money. If your finances are simple then you don't need a planner and such folks know that. Financial simplicity does not make money for a financial planner. What I refer to as "understandable complexity" is an absolute requirement for anyone in the business of financial planning or estate planning, if they hope to produce a steady stream of income from those that utilize their services. I myself have three simple rules.
1) Do what works.
2) Easier "is" better.
3) If it ain't broke, don't fix it.
Carl
Level 15

How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

Oh yes, there are times that putting rental into partnership, or an S-Corp or C-Corp does make sense. But I can't think of a single instance when it makes "sense" to put rental into a single member or multi-member LLC.
If two or more people own a rental property and those owners are not married and filing joint, then it makes sense to put the property into a partnership. Not a multi-member LLC per-se, but just a simple partnership. It makes the paperwork and division of income/expenses significantly simpler, regardless of the ownership percentage of each partner. Also makes reporting the sale that much simpler since the sale is reported on one single partnership return with any gains/losses on the sale reported on each partner's K-1, regardless of the ownership percentage.

Putting rental property into an S-Corp or C-Corp makes sense when you are "in the business" of acquiring property that is intended to produce income and that income is the primary source of one's financial needs. So this would come into play only if you have say, more than three rental properties and the cash flow from those properties provide more than half of your monthly and yearly income that one needs to survive and get ahead. I know of people in my own hometown here (don't know them personally, just know "of" them) that have 10-15 rental properties in an S-Corp and they depend on the cash flow from that property income to provide for their financial needs at the personal level. So for those folks, an S-Corp makes perfect sense.
Carl
Level 15

How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

As you enter the rental in the SCH E section of the business program, here’s the data and clarification you need to enter it correctly.

The open date of the business “must” be the date you “ORIGINALLY” acquired/purchased the property, or earlier. Then if asked separately for the “incorporation date”, that date “must” be at least one day “AFTER” you removed the asset/property for personal use on your personal return.

When asked for the acquisition date of the property and all assets, that date will be the “ORIGINAL” date you purchased it, acquired it, and/or placed it into service on your personal tax return. The only “sales expenses” you can claim on the business return are any costs incurred in transferring ownership of the property from you, to the business. At most you will most likely have title transfer fees, and that’s it. Since there won’t be any loan fees most likely, you will not have “any” sales expenses that will add to the cost basis of the property. Your title transfer fees are not capitalized and depreciated. Instead, they are amortized and deducted over 15 years or the remaining life of the loan. If you follow the prompts and interpret them correctly so that you answer the questions asked by the program correctly, the program will take care of this for you automatically.

Your “in service” date is the “original” date the asset was placed “in service” on your personal return.

The “business use percentage” will be the same 100% as on your personal return.

When asked for prior year’s depreciation already taken, it’s important to get this figure right, or you will not be taking the correct amount of depreciation on your business return. You’ll be double-dipping and the IRS will audit both the personal and the business return if this is not right. To get the correct figure you need for prior depreciation already taken, look at the information you wrote down earlier for this asset.

On what you wrote down from your personal return, you must add together the “prior depreciation” and “current depreciation” amounts. You will enter that total into the business return for this asset for the total of all prior depreciation already taken.  Then the program will figure the correct and pro-rated amount of 2018 depreciation for your 2018 business return.

When you add together the “current deprecation” amounts for 2018 from your personal return and your business return, that total should come “close” to the total depreciation taken on this asset in 2017. It may not be spot on exact, and that’s okay. So long as it’s within 5% or so, you’re fine.

I think that’s all the detail I need to cover for the business return. The “other stuff” is pretty much easy to figure out, understand and comprehend. When you’re all done with the business return the business will issue each owner (you and your spouse) your own individual K-1. Print those K-1’s and then go back to your personal 1040 tax return to enter them.

To enter them on your personal return it’s under the Personal Income tab in the Business Investment & Estate/Trust Income section. Under that heading elect to start/update the Schedule K-1 section and enter each K-1 one at a time, individually.

That should do it. Of course, if you have questions then by all means please ask.


Carl
Level 15

How should we report the income & expenses where we leased the property in our individual names for half the year and where the LLC leased the property for the remainder?

This post only covers dealing with this situation in your personal 1040 tax return. I'll cover entering it in the business tax return in a separate post in this thread.

First understand that all rental income and expenses is reported on SCH E. Period. Doesn’t matter if you’re reporting it on a 1040 personal return, 1065 partnership return or an 1120/1120-S corporate return. All rental income and expenses is reported on SCH E as a part of whatever type of return you are filing.

Start by getting it off the personal return. In this process there’s a lot of information you will need to write down as you go, because you will need that information when setting it up in the 1065, 1120 or 1120-S return. Regardless of what type of business return you’re filing, the transfer “process” is still the same.

On the personal 1040 return start by working through your rental “as if” nothing changed. You will work through and enter all rental income received and rental expenses incurred up to the date of the transfer. 

In the Property Profile section you must select the option for “I sold or otherwise disposed of this property in 2018.” When asked if the property was rented all year, you will say YES. It doesn’t matter if it sat empty for a month between renters. If you did not live in the property for one single day as your primary residence or second home in 2018, then it was rented all year.

In the Rental Income section you will report all rental income received before the date of the transfer. Doesn’t matter if you transferred on 6/30/2018 and they paid you a full year’s rent in advance prior to that date. You report every penny of that rental income received before the transfer date, regardless of what period(s) of time that income paid for.

In the Rental Expenses section you enter all rental expenses incurred and paid up to the date of the transfer. You will have to deal with three things that if not done correctly, you will be double-dipping on some deductible expenses and chances are you’ll raise flags at the IRS and get audited on it.  Those three things are mortgage interest, property taxes and property insurance. I’ll cover them in the order the program asks for those three expenses.

Insurance – You will have to pro-rate the insurance. What period of time in 2018 the insurance covers doesn’t matter, because it’s 12 months regardless of the start-stop dates of the currently active policy. So if you paid the policy premium for the year in Jan 2018 and the policy runs from March 1 2018 to Feb 28 2019 it doesn’t matter. If you transferred the property on Jun 30 2018, you will only enter 50% of the property insurance since the rental is owned by you personally for 50% of the year. Not 33% because the insurance premium you paid only covered the first 3 months of the policy.

Real Estate Taxes – The same rule applies here as above for insurance.

Mortgage Interest – You will pro-rate this the same as you pro-rated insurance and taxes.

Next is the “Sale of Property/Depreciation” section. If that section is named “Assets/Deprecation” then you need to go back through the Property Profile section and select the option for “I sold or otherwise disposed of this property in 2018.”

In the Sale of Assets/Deprecation section you must work through each individual asset one at a time to show it’s “disposition” on your personal tax return. Have pencil and paper handy because you will need to write down quite a bit of information on each asset, because when you enter it on the SCH E in the business program, things like the name of the asset need to match “exactly”.  The first asset listed (if you have more than one asset listed for this rental property) will be the property itself. Elect to edit it and let’s start working it through.

Write down “everything” on the Review information screen. You will need this information when you get to the business return. With one exception (covered below) everything must match “exactly” between the SCH E on the personal return, and the SCH E you’ll be completing on the business return.

Next screen is “Did you stop using this asset in 2018?”  Click the Yes button. Write down the “Date acquired” as you will enter this same exact date for this asset when you get to the business return. You need to enter the “date of sale or disposition” and this date needs to be one day “BEFORE” the business reports getting it. (Make “SURE” this date is the same for “ALL” assets, or you’ll have issues.)

Next screen is “Special Handling Required?”. Click YES on this screen.

Next screen is “Depreciation deduction amount” on this specific asset for tax year 2018. Write down this amount, as you will need it later when entering this asset on the SCH E in the business return.  Then click Continue.

You’re now back to the “Your Property Assets” summary screen. If you have other assets listed there, you must work through each individual asset just as you did the property asset, until you’ve got all the information I told you to write down for each individual asset. Once done, you can click the Done button on the “Your Property Assets” screen.

If you claimed “ANY” vehicle use/expenses on this rental then you must work through the Vehicle Expenses section and show the disposition of the vehicle. Basically, you’ll show the vehicle as “removed for personal use” and leave it at that, as I seriously doubt you transferred ownership of your vehicle to the business.

Now you can finish working through the rest of your personal 1040 tax return, but you can *NOT* file this return until "AFTER" you have completed the business return. This is because the business will be issuing you and your spouse each a K-1, which you will have to add to your personal return in order to file a "completed and accurate" personal return.

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