Father and Son own Son's Apartment

[Kram BergGold]

Father and Son paid cash for a condo for the son. Son paid 66% and Father 34%. Son has a roommate who pays rent. Father does not see any of the rent, makes no contribution for the upkeep of the unit. At some point the son will take out a mortgage and buy father out at an undetermined price. They want to report all rent on the son's return but I don't think that is permissable. Any one agree or disagree?

[Uncle Sam]

Father & Son Apartment

Is it a cooperative apartment or a condominium?

Regardless - they must report the income in the ratio of their ownership.

However - there's a problem here. Renting property to a relative brings up a whole
bunch of FMV issues.

I had this very issue on an audit over a year ago where father and son each owned
50% of a coop where the son was the tenant. Father attempted to show real estate
professional status by traveled mileage to son's unit to "maintain the place".
Since the case involved other issues - and was contested - I never got to complete the
audit.

But the issue of renting to a relative definitely brings up red flags.

[Gary2]

Idle speculation: Is there any possibility of treating this as a partnership where the father's share is limited to the capital appreciation, while the son gets all the current income? I haven't thought this through, so it may fall faster than a lead balloon on Jupiter, but there are obvious issues such as how the expenses are apportioned. I'm just curious if there's any potential at all in that direction.

As for the father renting his share to the son, I don't think that's an issue. As co-owners, whether as tenants in common or as joint tenants, they're each entitled to full use of the facilities absent any agreement to the contrary. So the son is not renting from the father. Rather, the father is simply choosing not to make personal, physical use of the property even though he has the right to do so.

[TAX4US]

I think that just because father does not see the rent does not mean he isn't entitled to it. Sorta like constructive income. Original post did not say son rents. I thought a roommate paid rent. I think maybe space occupied by roomate/total may give some leeway as to some deduction. I'm also thinking maybe 1065 with allocation of capital on way and allocation off profits/losses on a different %. Course then I may clear out of the ballpark on this. Lets see what others have to say.

[Bees Knees]

A 1065 is not required for joint ownership of rental property, unless services are provided in addition to the rental.

[Bees Knees]

IRS Pub 527 does say that a taxpayer must report rental income in proportion to his/her ownership interest in the rental property.

However, there could be a case made to say the son is the actual owner of the property and is entitled to 100% of the rental income and 100% of the deductions. There was a mortgage interest deduction case years ago that allowed a non-owner to deduct mortgage interest even though he did not own the house. A relative had helped him purchase the house due to poor credit, but he was ultimately responsible for all expenses. Thus, the Court said he could deduct the mortgage interest. (Uslu, T.C. Memo 1997-551)

In this case, if the father’s ownership interest is merely a form of financing for the son and the son is responsible for 100% of the expenses and entitled to 100% of any rental income, then I could see a Court say 100% of rental income and expenses go to the son because the father is not entitled to any of the rental income.

[Bees Knees]

In reality, if the reverse were true, you can bet the IRS would allocate 100% to the father. For example, let’s say the father purchases rental property for his college aged son to live in. The father also rents out rooms to roommates. The father collects 100% of the income and pays 100% of the expenses. The father is in a high tax bracket. The son is in the zero percent tax bracket. The father transfers 50% ownership in the property over to the son while retaining 100% of the net rental income. The father thus attempts to shift 50% of the rental profits from his high tax bracket to his son’s zero percent tax bracket, while keeping all of the money.

You think for one minute IRS would go for that?

[Gary2]

IRS Pub 527 does say that a taxpayer must report rental income in proportion to his/her ownership interest in the rental property.

Curiously, Pub. 527 says two different things for income and expenses. For income, it says "If you own a part interest in rental property, you must report your part of the rental income from the property." For expenses, it says "If you own a part interest in rental property, you can deduct expenses you paid according to your percentage of ownership." Now we all know that the pubs aren't authoritative, and it's possible that this inconsistency is an oversight rather than a conscious distinction.

Also, while Pub. 541 says "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.", I'm not so sure I'd take this literally. For one thing, you can work around it by putting the property into an MMLLC. But also, it would seem to prohibit a perfectly legitimate arrangement in which the rents, for sound business reasons, aren't intended to be allocated proportionately. For example, if you have two unrelated owners, with one totally uninvolved in decision making while the other seeks out and approves all the tenants, collects the rents, performs routine maintenance (e.g. lawn mowing and snow plowing - which do not bring it to the level of a business), and so on, it would be justifiable, from a business perspective, to give that person a guaranteed payment at say 10% of the gross rental income.

In this particular case, it would be much more difficult to come up with a business reason to allocate all of the gross rent to the son, so I don't think we should walk down this path any further.

[Bees Knees]

In this particular case, it would be much more difficult to come up with a business reason to allocate all of the gross rent to the son, so I don't think we should walk down this path any further.

Why?

The son gets 100% of the rental income and pays 100% of all expenses. It also appears the father is an owner merely because the son couldn't afford to purchase the condo all by himself at the time. The intendt is for the son to eventually buy out the father when he can afford to. The father receives no economic benefit from the rental activity.

Under those facts, why would it be difficult to come up with a business reason to allocate all gross rent to the son?

[Bees Knees]

Like I said before, if the situation were reversed and it was the father collecting all income, and the father was in a higher tax bracket, you can bet that under the economic substance doctrine, the IRS would want to allocate all income to the father and ignor the son's ownership interest.

[Gary2]

Why?

The son gets 100% of the rental income and pays 100% of all expenses. It also appears the father is an owner merely because the son couldn't afford to purchase the condo all by himself at the time. The intendt is for the son to eventually buy out the father when he can afford to. The father receives no economic benefit from the rental activity.

Under those facts, why would it be difficult to come up with a business reason to allocate all gross rent to the son?

Because if the only benefit is for the father to be bought out by the son for an undisclosed price, so that the son is treated as 100% beneficial owner, then it's a disguised loan and the father must declare the imputed interest income, and possibly the gift of the interest income to the son (assume the son doesn't actually pay interest to the father). There would have to be a significant tax savings to justify the complication, as well as some legal research. If there were some sort of agreement guaranteeing a profit for the father, or a market analysis that could reasonably predict a capital gain profit that would reasonably compensate the father for his investment, that might be different.

The original poster is located in MA. We don't know if the property is in MA, but assuming it is, then this relatively recent Tax Court case suggests that establishing equitable ownership in MA cannot be done as easily as in some other states, because of the requirement that the agreement be in writing. However, I'm not prepared to rule it out, just merely assert that it requires more legal research.

[Bees Knees]

Not sure I agree.

If this were a partnership, and one partner incurred all expenses and collected all income, under the special allocation rules, this would be allowed. 50/50 partners in capital, while 100%/0% allocation of profits and losses. As long as the one claiming 100% of profits and losses actually receives 100% of the profits and losses, it passes the economic substance test. The other partner is merely a partner in the capital of the underlying property.

Perhaps that could be the approach in this case. Have the son and father form a partnership with the father owning 34% of the partnership and the son the other 66%. Then have them contribute the condo to the partnership. Then make a special allocation of the profits interest so that the son receives and pays tax on 100% of the rental profits while the father receives zero. The father thus only receives a 34% capital interest in the partnership and a zero percent interest in the profits. As long as this special allocation is written into the partnership agreement, it passes the economic substance test.

[Gary2]

Not sure I agree.

If this were a partnership, and one partner incurred all expenses and collected all income, under the special allocation rules, this would be allowed. 50/50 partners in capital, while 100%/0% allocation of profits and losses. As long as the one claiming 100% of profits and losses actually receives 100% of the profits and losses, it passes the economic substance test. The other partner is merely a partner in the capital of the underlying property.

Perhaps that could be the approach in this case. Have the son and father form a partnership with the father owning 34% of the partnership and the son the other 66%. Then have them contribute the condo to the partnership. Then make a special allocation of the profits interest so that the son receives and pays tax on 100% of the rental profits while the father receives zero. The father thus only receives a 34% capital interest in the partnership and a zero percent interest in the profits. As long as this special allocation is written into the partnership agreement, it passes the economic substance test.

That's basically what I had in mind when I first tossed out the idea. I'm not as confident that it passes the economic substance test, but I'll admit that my mind had erroneously transposed the respective percentages (thinking it was the father who had contributed the 66%). It's more plausible with the father only putting in the 34%, but I wouldn't stake my reputation on it passing muster without more research. Doesn't there have to be some benefit given to the father in exchange for giving up his share of the rental profits?

[JohnH]

If the intent is for the son to eventually get a loan and buy out the father, then why not have the father go ahead and sell to the son now? He can owner-finance, interest only, with a balloon payment in a few years. This cleans up the deal and puts a little pressure on the son to get it done. Dad can always extend the note when the balloon comes due if he chooses to do so. He retains the same degree of control he presently has (essentially none), plus the tax complications on the rental go away.

[Burke]

I have been out of town since 5/10, and just now reading this thread. Was going to post the very same thoughts as JohnH just did. Written documentation or a promissory note to the father for his contribution would probably clear up this matter and allow full ownership to be transferred to the son on the deed subject to a mortgage allowing full rental benefits to the son. It was not apparent to me that the son was paying any rent.