Co-ownership of Rental Real Estate Does Not Require Partnership Formation - John R. Dundon II, Enrolled Agent
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Co-ownership of Rental Real Estate Does Not Require Partnership Formation

Business Entity Selection and the Tax Consequences of Converting

Co-ownership of Rental Real Estate Does Not Require Partnership Formation

Generally co-ownership in rental property does not require the formation of a partnership when the following conditions are met.

1. Each co-owner must hold title to the property as a tenant in common (TIC) under local law. This usually doesn’t apply community property. Although the title to the property can’t be held by an entity, an individual tenant-in-common should be able to own his TIC interest through a single member limited liability company (SMLLC). A co-owner is defined as any person that owns an interest in the property as a tenant in common.

2. The number of co-owners cannot exceed 35 people as per Code Sec. 7701(a)(1). A husband and wife are treated as a single person and all persons who acquire interests from a co-owner by inheritance are treated as a single person.

3. The co-ownership must not execute a partnership agreement and the co-owners must not hold themselves out as having formed a partnership or other form of business entity. In addition, the co-owners must not have held interests in the property through a partnership or corporation immediately before the formation of the co-ownership.

4. The co-owners may enter into a limited co-ownership agreement that may run with the land and the co-owners must retain certain voting rights. However certain restrictions on the alienation of a co-owner’s interest are allowed.

5. If the co-tenancy property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds distributed to the co-owners.

6. Each co-owner must share in all revenues generated by the property and all related costs in proportion to the co-owner’s undivided interest in the co-tenancy property. For example the co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.

7. A co-owner may issue an option to purchase another co-owner’s undivided interest, provided that the exercise price reflects the fair market value of the co-tenancy property at the time the option is exercised.

8. The co-owners’ activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property.

9. The co-owners can make management or brokerage agreements that are renewable annually or longer.

10. All leasing arrangements must be legitimate leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property.

11. The lender on any debt that encumbers the property or on any debt incurred to acquire an undivided interest in the property is not a related person to any co-owner, the sponsor, the manager, or any lessee of the property. This is where many people seem to get dinged particularly when a parent or other related party lends money to a child so that the child can buy an undivided interest in the property even if the parent isn’t a co-owner.

A related person is a person bearing a relationship described in Code Sec. 267(b) which bars the deduction of losses on sales to related persons or Code Sec. 707(b)(1) which bars losses on sales between partnerships and controlling partners or related partnerships.

12. The amount of any payment to the sponsor for the acquisition of a co-ownership interest reflects the fair market value of the acquired co-ownership interest and does not depend on the income or profits derived by any person from the property. A sponsor is any person who divides a single interest in the property into multiple co-ownership interests for the purpose of offering those interests for sale.

The point of this post is that because partnership interests are not eligible for like-kind exchanges when co-owning real estate it is important to understand the interests of the other co-owners before engaging.