Should A Husband/Wife Form an LLC to Invest In Real Estate?
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Should A Husband/Wife Form an LLC to Invest In Real Estate?

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Should A Husband/Wife Form an LLC to Invest In Real Estate?

Should A Husband & Wife Form an LLC to Invest In Real Estate? Literally the $1,000,000 question.

A husband and wife formed a Limited Liability Corporation (LLC) that invests in rental real estate to protect themselves in event of a lawsuit. They want to know if they formed the most appropriate business structure and whether their rental activity is reported on IRS Form 1040 Schedule E.

Pursuant to the rules of professional conduct set forth in US Treasury Department Circular 230 nothing contained in this blog was intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.

This question raises a number of collateral issues which are not readily apparent from the skeletal statement of facts, but which require some consideration when addressing the underlying issues.

Income from a rental property owned by one person is generally[1] reported on page 1 of Schedule E.  The same is true if the rental property is owned by a husband and wife who elect to be treated as a single taxpayer by filing a joint return.  However, if the property is owned by two or more persons who are not spouses, and who cannot therefore elect to file jointly, the reporting treatment depends upon the nature of the activity in the venture (addressed more fully below).

In the present case, however, the rental property is actually owned by the limited liability company which is, in turn, wholly owned by the spouses.  This tiered ownership structure adds a level of complexity to the analysis.  If only one spouse owned the entire LLC interest, then the LLC would be considered to be a “disregarded entityâ€[2] for tax purposes and the rental activity would still be reported on page 1 of the Schedule E.  However, if the LLC is owned by two persons, it is not considered to be “disregarded†and the LLC would have a separate tax filing requirement.  In that case, each “partner†would receive a form k-1, and the income from the venture (partnership) would be reported on page 2 of the taxpayers’ Schedule E.

But wait!  What if the only owners of the LLC holding the rental property are spouses who elect to be treated as one taxpayer (by filing jointly).  Are they entitled to any special consideration in determining whether the interests must be reported as a separate entity?  Sadly, they are not.  With one notable exception, an LLC owned by two persons, regardless of their relationship, is considered a separate entity for filing purposes.

With regard to the “notable exception†mentioned above, one should note that the above discussion assumes that the spouses are not living in a community property state.  The IRS has acknowledged[3] that spouses living in a community property state may elect to treat their co-ownership of a business entity formed under the laws of that state as a disregarded entity for federal tax purposes.  In this limited instance, the spouses could elect to disregard the entity in the same manner as a sole member of an LLC in any other state, and report the income on page 1 of Schedule E.

That said, there are several provisions in the Code and Regulations that raise interesting possibilities and to which one might be drawn when counseling the taxpayers in this case.  The tempting nature of these provisions warrant some additional discussion.

Anytime there is an association of persons engaged in an endeavor, and the participants have not taken the additional step of formalizing the terms of the venture, perhaps with formal organization (i.e., a corporation or LLC), or simply with a formal document (partnership agreement, etc.), a certain amount of confusion must necessarily follow.  It appears that the principal reason for the amount of confusion which typically accompanies an analysis of a client’s “joint venture†is the terminology itself.  For tax purposes, the term “joint venture†has been defined as a “special combination of two or more persons, where in some specific venture a profit jointly sought without any actual partnership or corporation designation.â€[4]  Thus, the tax compliance requirements which more naturally accompany the formal organization of a corporation or LLC, or even the imposition of a simple partnership agreement, become more obscure when dealing with a joint venture, or even mere co-ownership of property.

Under the “check-the-box†regulations[5], the default classification of a joint venture is a partnership.  It is encouraging, however, that those regulations also acknowledge that mere co-ownership of property does not necessarily create a separate entity.  Something more is needed to raise the ownership to the level of a reporting partnership.  For example, mere cost sharing arrangements, or even co-ownership of property that is maintained, kept in good repair and rented does not constitute a separate entity for tax reporting purposes.  But if the venture is a trade or business, or is a co-ownership venture which also provides services in connection with a mere rental activity (whether directly or through an agent), the venture assumes the mantle of a reporting entity.  The problem in the case before us, is that there is no co-ownership of the rental property.  It is clearly wholly owned by the LLC.  The co-ownership is of the LLC, which is treated in much the same manner as that of co-ownership of a corporation.[6]

Another tempting provision is contained in IRC §761(a), which provides a definition of what constitutes a partnership for federal tax filing purposes (including a “joint ventureâ€), and also provides that members of an unincorporated organization may elect out of Subchapter K (partnership reporting requirements) in three limited instances,[7] one of which arises where the venture is availed of for investment purposes only, and not for the active conduct of a business.  This election requires[8] that the co-owners (1) own the property as co-owners, (2) reserve the right separately to take or dispose of their shares of any property acquired or retained, and (3) do not actively conduct business (whether directly or through an agent).  Again, the co-ownership requirement limits the application of the provision in this instance.  The use of a state recognized entity such as a corporation or LLC[9] disqualifies the taxpayer from using this provision.[10]

There has also been some confusion regarding the application of the “Qualified Joint Venture†(“QJVâ€) rules of IRC §761(f) which became effective for tax years beginning after 12/31/2006 and which allow a husband and wife to report a jointly owned trade or business on separate schedule C’s[11] rather than having to file a separate file partnership return.  This election is only available where (1) the only members of the joint venture are a husband and wife, (2) both spouses materially participate (within the meaning of IRC §469(h), i.e., the “passive activity rulesâ€), and (3) both spouses elect the treatment.  It also requires that the spouses be conducting a trade or business: mere joint ownership of property does not qualify for the election.[12]  In addition, the election to be treated as a QJV is not available when the venture is held in the name of a state law entity such as a partnership or LLC.[13]

Thus, unless the owners elect some other entity classification under the “check-the-box†regulations, the spouses in our case will be required to file a partnership return for the LLC and each report their share of the financial activity of the LLC on page two of their joint Schedule E.

For more information on this please feel welcome to contact me any time.

[1] Presumably, if the amount of rent related activity rises to the level of a trade or business, even rental income would be seen to be a trade or business, reportable on schedule C and subject to SE tax.

[2] See Treas. Reg. 301.7701-2(c)(2)(i).

[3] See Rev. Proc. 2002-69, 2002-2 CB 831 (10/9/2002).

[4] See Haley v. Commissioner, 203 F.2d 815, 818 (C.A. 5, 1953); Aiken Mills v. United States, 144 F.2d 23 (C.A. 4, 1944); Tompkins v. Commissioner, 97 F.2d 396 (C.A. 4,  1938).

[5] See Treas. Reg. 301.7701-1(a)(2).

[6] One sees this argument particularly in connection with like kind exchanges under IRC §1031, in cases where the “partners†wish to liquidate the property and some want to utilize the §1031 deferrals, while others just want to “cash-out.â€Â  This is a problem as the like-kind exchange can only be accomplished by the owner (i.e., the LLC) and will impact all of the partners in the same manner.

[7] We will ignore the other two instances where taxpayers can elect out of Subchapter K, as they are not relevant to this discussion.

[8] See Treas. Reg. 1.761-2(a)(2).

[9] An LLC owned by more than one person is treated as an “other business entity†pursuant to Treas. Reg. 301.7701-2(c), i.e., not a corporation and not a disregarded entity for tax purposes.

[10] Treas. Reg. 1.761-2(a)(1) specifically excludes from this election out of Subchapter K “Any syndicate, group, pool, or joint venture which is classifiable as an association, or any group operating under an agreement which creases an organization classifiable as an association.â€

[11] There is an additional collateral issue if QJV spouses elect to treat rental properties as QJV’s.  Since they are, in essence, taking the position that the activity constitutes a business reportable on schedule C, the question arises as to whether the net rental income is then taxable for self-employment purposes.  In a 2008 Chief Counsel Advice (CCA 200816030, 4/18/2008), the IRS, deferring to IRC §1402(a)(1), has clarified that if income is otherwise excludible from net earnings from self-employment under §1402(a), the election of QJV status does not convert such income to net earnings from self-employment.

[12] See CCS 200816030, Ibid.

[13] See page 2 of the 2010 instructions for form 1065.”