Partner Living in Partnership Property

[kdhill]

I have a client that is a partnership that owns a residential property. The partners in the partnership are three brothers. One of the brothers is living in the property and paying FMV for the personal use of the property. I'm supposed to prepare a partnership tax return for the partnership. Since one of the partners is living there, I believe this becomes personal and not business use and so I don't even know if a partnership return should be filed at all. Would it change anything if the brother living in the house had his significant other on the lease instead of him? Thanks in advance.

[Rapid Robert]

I don't think there is anything wrong in principle with the partnership return, so I wouldn't try to eliminate it (I assume you are taking over an entity which filed in a previous year?). I haven't thought it through all the way and have not had such a client, but a few things come to mind.

• The partner-occupant has a self-rental situation. I would not advise anyone to put their S.O. instead of themselves (as partner) on an important business lease of real estate owned by the partnership. That's a legal question, not a tax question.
• It is a rental to a related party (but if paying FMR rate, not a problem)
• Is the partnership typically profitable or generating a loss? Can make certain issues less important than others.
• Is the partner-occupant losing the opportunity for a partial Sec 121 exclusion upon sale? (whatever the sale plans may be) Still generating Sec 1250 gain upon sale, right? (assuming price increase on property)

I'd start saying more things about Schedule A vs. Schedule E (for partner-occupant) but better stop now since I haven't researched any of it yet.

[terryats]

This is from the tax adviser: The only exceptions to the personal use allocation rules are where the partnership rents the property to a partner or related party for use as that person’s principal residence. Here is the link, so you can read the whole thing: https://www.thetaxadviser.com/issues/2012/may/hagy-banner-may2012.html

[kdhill]

Hi Robert, This partnership is brand new in 2019 and so has not generated any prior losses or profits. From what I can tell so far, it will generate net income because there is no mortgage. If there is $2,000 of net income for 2019, do they each pay tax on 1/3 of that? The personal use of the property really muddies things up. Most of the information that I've found pertains to property used part of the time for personal use and part of the time as a rental property. This is property used 100% of the time for personal use, but only by one of the partners.

[TaxGuyBill]

This partnership is brand new in 2019 and so has not generated any prior losses or profits.

Why do you say this is even a Partnership and a Partnership return should be filed? It certainly does not seem like a business. Is it owned by their multi-member LLC or something?

My first thought it is merely co-owned by three brothers. The person living there would not report anything, and the two other brothers MIGHT report rental income on page 1 of Schedule E. Even that is debatable if that would be required.

[kdhill]

Why do you say this is even a Partnership and a Partnership return should be filed?

They formed an LLC and received a federal ID number for a partnership.

It certainly does not seem like a business. Is it owned by their multi-member LLC or something? Yes

My first thought it is merely co-owned by three brothers. The person living there would not report anything, and the two other brothers MIGHT report rental income on page 1 of Schedule E. Even that is debatable if that would be required.

Yes, it's debatable and not clear to me which is why I'm posting this question. So, maybe the other two brothers will treat this like they own 1/3 of a rental property, depreciate 1/3 each and report it on schedule E instead of reporting it on a partnership return? That does make the most sense.

[TaxGuyBill]

Unfortunately, if the LLC owns the house, the brothers can't report it on page 1 of Schedule E. But you may want to check if the LLC actually does own it.

Just because they have a LLC and an EIN doesn't automatically mean it is something that needs to be filed on a tax return. I think I would ask more questions to the client about WHY they set up this situation. Is there really a profit motive? Or are the other two brothers just helping out their other brother?

Is the one brother paying Fair Market Rent?

[Rapid Robert]

I partially agree with TaxGuyBill (and don't disagree with him, just seeking more info and checking my assumptions). I agree the "partnership agreement" must be consulted.

An EIN generated for a federal partnership will most likely require a return filing. Also, for California at least, a state LLC tax return would need to be tied to a federal filing of some kind. The question now is, for legal purposes, is this a SMLLC or MMLLC? Makes a big difference, and I think it is a matter of what is recorded at the state level, not what the taxpayer wishes it would be.

I initially asked about prior year returns for this very reason -- does this really need to be reported as a partnership? Like TaxGuyBill said, I could see this just being reported as expense and income sharing on individual Form 1040 Schedule E page 1. But, again, I see nothing wrong with actually treating it as partnership, and in a lot of ways, that would be more tax-accurate for all concerned.

I don't see "personal use" as a problem. If the tenant is paying FMR (fair market rental) and the partnership can document same, then it is business use. Maybe a self-rental, but what does that mean - non-passive treatment (have not bothered to look it up).

QBI deductions? Sec 1250 gain and Sec 121 exclusion? Non-passive losses? So many possibilities! ??

[Rapid Robert]

so you can read the whole thing: https://www.thetaxadviser.com/issues/2012/may/hagy-banner-may2012.html

You forgot to add the most relevant part after what you quoted: "The only exceptions to the personal use allocation rules are where the partnership rents the property to a partner or related party for use as that person’s principal residence. The following discussion does not pertain to this type of rental arrangement. "

[kdhill]

Unfortunately, if the LLC owns the house, the brothers can't report it on page 1 of Schedule E. But you may want to check if the LLC actually does own it.

Yes, the LLC actually owns the property.

Just because they have a LLC and an EIN doesn't automatically mean it is something that needs to be filed on a tax return. I think I would ask more questions to the client about WHY they set up this situation. Is there really a profit motive? Or are the other two brothers just helping out their other brother?

Is the one brother paying Fair Market Rent?

Yes, he's paying fair market value for the rental. There is no partnership agreement. It was just three brothers that inherited a house from their mother and one brother decided he wanted to live in it. I guess he didn't want to buy the other brothers out (or couldn't), I don't know.

[TaxGuyBill]

Unfortunately, it seems like it needs to be reported on the Partnership return as a rental. If the LLC is officially charging 'rent', that seems like how it needs to be done.

But this arrangement just doesn't makes sense to me. The brother that lives there will be PAYING income tax for living there. That is just bizarre to me. In my opinion it should not have been put in an LLC. That is needlessly complicating things for tax purposes.

[kdhill]

Agreed. They formed this partnership and put the property in it before they hired me. I don't think they consulted any sort of professional when they did it. Now I have the headache of figuring out what to do. If I file it on a 1065 return and treat it as 1/3 personal use, then 2/3 will be rental property. Do I only include 2/3 of the gross income and 2/3 of the expenses on the return? Is the net income that results then divided three ways?

[TaxGuyBill]

No, because it is rented at Fair Market Value, I think it should be 100% rental use.

[kdhill]

Okay. I see your point taxguy. He's paying FMV to live there so I'll file the 1065 on 100% of income and expense and he'll get to pay tax on his 1/3 of the profit. Thanks for everyone's input on this!

[Rapid Robert]

Okay. I see your point taxguy. He's paying FMV to live there so I'll file the 1065 on 100% of income and expense and he'll get to pay tax on his 1/3 of the profit. Thanks for everyone's input on this!

That was the same point I made about no personal use if paying FMR.

Why does the profit have to be split 3 ways evenly? What does the partnership agreement say? If you look at Schedule K-1(1065) you will see that a partner can have different percents of the partnership profit, loss, and capital. Also, paying tax on "profit" now is just a timing difference, right (since he would be increasing his basis in the partnership)? Plus, under this arrangement he gets to deduct his share of depreciation, insurance, repairs, QBI, etc, that a regular homeowner does not get to deduct.