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Hey there, fellow real estate investors, FIRE enthusiasts, and tax aficionados! Welcome to "Real Estate is Taxing" – your go-to weekly podcast for all things real estate taxes, hosted by Natalie Kolodij, EA- Real Estate Tax Strategist and dry humor extraordinaire.
Each week, we're breaking down complex tax topics into bite-sized, understandable explanations, with no regard for how many obscure references it takes to get there.
Speaker: Welcome to Real Estate is Taxing,
where we talk about all things real estate
tax and break down complex concepts into
understandable, entertaining tax topics.
My name is Natalie Kalady, I'm
your host, and I am so excited
that you've decided to join me.
Microphone (Shure MV7): Hello everyone.
And welcome to today's episode.
So every single year, Without fail.
There is at least one circumstance.
Where I run across a partnership return.
After the partnership deadline.
That is there because they client.
Accidentally created a partnership.
They didn't realize they made this.
And I know what you're thinking.
Natalie.
How does that happen?
How does someone accidentally
create an entire partnership?
Well, we're going to talk about it.
Let's first start with a few
key facts about partnerships.
So a partnership is filed on form 10 65.
It is a completely different
tax return from your 10 40,
from your personal tax filing.
And as a whole, it requires a lot more
information then reporting the same
activities would on your personal return.
So if you have a partnership, if you're
reporting a 10 65, You have to track
more things, including a capital account.
You have to track basis.
You have to keep a balance sheet.
And to really do all of that correctly.
You pretty much need to have actual
books and you need to have correct
bookkeeping done in bookkeeping software.
Not just sort of pulling together
your receipts at your end.
It's really hard to do that and
have everything tie out correctly
with all of the information
needed on an entity tax return.
So when you have a 10 65,
a partnership tax return.
Everything gets reported on that return.
Right?
So if you have a rental.
The rental goes on the 10 65,
all of the income and expenses.
Everything goes on to that
partnership tax return.
And then once that return is finished.
A K one is generated for each
partner in the partnership.
This is kind of like
receiving a W2 from your job.
It is each partner's recap.
It is their summary.
Of income or loss for the year.
And any other kind of
little details that matter.
It will have a few other
pieces of information.
But so the partnership is where
everything is reported and it calculates,
and it figures out the end number.
And then each partner receives a K one.
That says, Hey, here's your share.
This is your amount of income,
or this is your amount of loss.
So that K one.
Is then entered on the
personal tax return.
On the 10 40 and that's
where it's accounted for.
So partnership itself, you don't
pay tax on the partnership.
It then creates a form.
And you reported on your
personal return and that's where
any net tax impact happens.
So here's where things
get a little squirrely.
Is a personal tax return, right?
Your personal 10 40 tax return.
Is due April 15th.
A partnership.
Is due March 15th.
This makes sense, because to
finish your personal return.
You would need that K one
from your partnership.
So the partnership has to be done first.
So what happens pretty frequently?
Is if someone doesn't know where,
like, if you don't realize that
you had created a partnership.
And it's now April tax.
Repair's going to do your personal taxes
that aren't due for a few more weeks.
And when going through your
documents, What they find.
Is the setup of this LLC.
And it turns out to be a partnership.
Well, shoot, this is problematic.
Because now we have a partnership.
And we learned, it takes
a lot more information.
There's a lot more you have to do for it.
We don't have any of that
because we weren't expecting it.
And it's late.
So what can we do?
So there are a few things we can
do when we run into this situation,
because I am telling you guys, it
happens far more often than you think.
Before we get into the solutions.
Let's walk through some of the more
common ways that this comes up.
Like, how does this happen?
How do people create an
accidental partnership?
At a starting point.
An LLC.
That has two or more members
creates a partnership.
So if you create an LLC with
just your name, It's disregarded.
To the IRS.
It doesn't exist.
Betterly it does nothing.
It doesn't change your taxes at all.
It doesn't change where you file at all.
It just creates this legal separation.
The rental or the business, whatever it
was, gets reported, the exact same way
as it would, if you did not have the LLC.
Once you add a second person.
It's a partnership and we have that
whole separate return on form 10 65.
So one of the most common ways we
have an accidental second person.
Is with a married couple.
It is incredibly common for a married
couple to just think like they're so
used to doing everything together.
So they set up the LLC and they
just put both of their names on it.
Like that seems like a totally
reasonable thing to do.
And it's not wrong.
But most of the time we've
created a partnership.
So that I would say is one of
the most common ways I see an
accidental partnership come up.
When it wasn't the intention right there,
wasn't a goal of creating a partnership.
They didn't know they were going
to have another tax return.
It was just a, did not realize that
was the outcome of putting both
of their names on the paperwork.
So here is solution number one, if
you've got an accidental partnership.
So if this is the circumstance
that applies to you.
Or applies to your client, right?
We have a taxpayer and spouse.
Accidentally put both
their names on the LLC.
What do we do?
Solution number one.
In a community property state.
If there's an LLC where the only
members are the taxpayer and spouse.
They can instead choose to
be treated as disregarded.
Because of those unique state laws
and community property states.
Where everything is sort of shared.
The way this is handled.
Is that in a community property state,
only a taxpayer and spouse who are both
members on an LLC can instead choose
to have it treated as disregarded.
So they can be viewed as one unit.
So it's treated the same way
as if there was only one owner.
Of that LLC.
And you would file it
exactly the same way.
What allows you to do this
is rev proc 2002 dash 69.
And what happens here is that
instead of having a file that's
separate partnership tax return.
If we have an LLC.
Only two members are the taxpayer
and the spouse, and they're
in a community property state.
We can use this rev proc and file it
as though it was a single member LLC.
Instead.
So that's your first solution.
But this really only helps.
For community property states, right?
So let's talk about some of the
other ways this happens that this
comes up accidentally and other
solutions and what we can do about it.
The next most common
accidental partnership.
I see.
Is the accidental partnership
that can happen without an LLC.
So two people who are just carrying
on a trader business together, you're
just running a business like a shared
business together, an active business.
That creates a partnership.
So if you and a friend are renovating
properties together, You're flipping
houses together, buying it in both of your
names, fixing it up, selling it, splitting
the profit, doing it over and over.
That can create a partnership and
that would require a 10 65 tax return.
So even though there wasn't an LLC.
Even though there wasn't
a multi-member LLC.
Two people carrying on an active
trader business together, it
can create a partnership and
require a partnership filing.
But again, I have good news.
And I have some potential
solutions for you.
First option for a solution.
There's an exception to this.
Specifically for rental properties.
It is stated in the code that the
mere co-ownership of a property.
For the reason of it being
held for lease or for rent.
Does not create a partnership.
Unless there are also services provided.
So if you and a friend.
Buy a property together that
you're going to just rent out.
And then each year you're
going to each report your half
on your personal tax return.
That's totally.
Okay.
On a rental property.
We've got this exclusion,
you and someone else.
So two people can own a property together.
That's held for rent.
And not create a partnership.
If you and someone else buy a property
together to renovate flip sell, and
you're doing that over and over again.
We might have a partnership, so
active trader business partnership.
If all you're doing is
coning a rental together.
We don't have a partnership.
So that's the first piece
of good news, right?
That's the first solution is.
If it's a rental, we don't have
to worry about this same problem.
The next option.
Is if.
We are operating an active
trader business, right?
Again, if two people are operating
an active trader business together,
it normally creates a partnership.
Unless.
It is a taxpayer and spouse who are
operating this business together.
And there are no other members
of the business, right?
It is only the taxpayer and spouse.
So in this circumstance, we
have a nother option here.
We have something else
we can do for a solution.
So if it's only a taxpayer and spouse
who are operating an active business
together, they have the option of
instead filing a qualified joint venture.
So instead of having a file on
form 10 65, instead of having
to report like a partnership.
They can report a qualified
joint venture, which qualifies
for any unincorporated business.
And what happens in that
case is that each spouse.
Reports their own schedule C.
So like if they're flipping houses,
they each report their own schedule,
see their own business on the return.
And they each report half of everything.
Both spouses do have to be
participating in the business.
And it does have to be split up between
the two forms that way on the one personal
return, they file a 10 40 together.
But we have two different businesses.
They each have pretty
much half of the business.
And they each get credit paid
in toward social security for
that self-employment income.
So that's your second solution.
Right?
First solution is.
If what is being operated
together is a rental.
We don't have a partnership.
Second one is if the people operating
an active business together.
Our taxpayer and spouse.
We have the option of instead
reporting as a qualified joint venture.
Okay.
So now what you guys are thinking as well,
Natalie, none of those things apply to me.
Right?
What if I just created an LLC with
my spouse or with a friend we're
not in a community property state.
We bought some rentals, like,
what is the solution here?
Like what do I do?
I didn't realize we did this.
How do we fix it?
Do we have to file this 10 65?
What are my options?
Now we're going to go into
a series of questions.
To see how to best fix this,
to see what your options are.
First question.
So you and someone else
created a two person, LLC.
You put both of your names on the LLC.
You're now learning.
This is a partnership.
What happens?
Did that partnership?
Actually own the rentals or did you.
Right.
So the first kind of get
out of jail free card.
I would be, if you and someone else
created this LLC together, which would
normally require a partnership tax return.
You set it up because you're
going to, you know, purchase
rentals and run rentals together.
But you never put the rentals in the LLC.
Right.
If that LLC doesn't actually
own those properties.
You do not have to file that
partnership like that partnership
is not an actual partnership.
If it is not.
Owning the assets.
It is not functioning.
It is not actually doing something.
So your first option here for something
to look at, to see if you really have
to file this partnership tax return.
Is that if you set up that multi-member
LLC to operate these rentals in, were
the rentals actually ever put in the LLC?
A partnership shouldn't report
assets and report the rental
income and report rentals.
It doesn't own.
So if those were never moved into there,
You've got an option to look at there.
Talk about it with a tax professional, or
if you're a tax professional, look over
this and discuss it with your client.
If that partnership doesn't
actually own the rentals.
We might be good.
Right?
You guys own these rentals,
you co-owner rental.
And like we learned earlier,
More than one person.
Co owning a property for the
sake of rental or leasing it.
Does not by default bank a partnership.
So you might be good.
That could be totally fine.
Because you didn't actually take
the second step of putting the
properties, titling them into the LLC.
Second question.
Did the partnership have any income or
deductions or credits during the year?
So if you dive in to the code
section on this and to CFR
one dot 6 0 3, I think it is.
It specifically states.
That a partnership.
That does not have any income or
deductions or credits for the year
does not have a requirement to file.
This comes up pretty often as well.
If you set up this LLC with yourself and
your spouse or yourself and a friend,
you're going to buy rentals together.
You set it up in November.
Nothing has happened.
You haven't bought a property yet.
You maybe bought a property.
But it's not in services or rental yet.
All of those costs before you're
in service, just get added to the
basis of the property typically.
So there are a lot of circumstances
where if you've created a partnership.
But if it didn't actually have any
income or expenses or reportable
things for that year, You might
not have a filing requirement.
So that is kind of your
second thing to check.
First one, does this partnership
actually on the properties?
Second one, does it actually
have income or expenses?
Because if it doesn't.
You might not need to file.
if none of those come into play, we do
actually have to file a partnership.
But now it's late.
We found out about it after the fact.
Now, what do we do?
Microphone (Shure MV7)-1: Well,
If your partnership has less than
10 people, 10 or less partners,
and you meet a few other criteria.
There is a rev proc that allows us
to not incur that late file penalty.
So this is late file relief under
rev proc eight four dash three five.
And.
If your partnership is going to be
filed after that deadline, if you
meet these criteria, you can cite this
rev proc you can reference back to
this to have the penalties removed.
Your partnership has to
have 10 or fewer partners.
Each partner has to
either be an individual.
Or the estate of a deceased partner.
Each partner's items of income, deductions
and credits have to be allocated in
the same proportion as all other items
of income, deductions and credits.
So we can't have a bunch
of special allocations.
And the partnership has to have
not elected to be subject to the
consolidated audit procedures
under IRC 6 2 2 1 and 6 2 3 3.
So this relates to the centralized
partnership audit regime.
Which most partnership
should probably elect out of.
We'll talk about that in a sec.
So as long as you're not opted
in, you've elected out of
the centralized partnership.
Audigy.
And this last one is key.
Each partner.
Reported his or her share of
partnership income on his or her
timely filed income tax return.
So what this means.
Is if you're a tax professional or if
you're a client of your tax professional
is looking through your stuff.
It's April 10th and that's when
they find this partnership.
Your 10 40 isn't due till April 15th.
It's not late yet, but
your partnership is.
As long as this late partnership.
Met these other criteria.
And you reported the correct income
and expenses on each partner's 10 40.
That was filed by that
April 15th deadline.
Or you had extensions in place.
You've meet these criteria.
So if a surprise partnership,
an accidental partnership.
Is discovered late, which
happens all the time.
There is a good chance you
can use rev proc 84 dash 35
to remove that late filing.
If you meet these criteria.
The last item that I will touch on.
Is that C par centralized
partnership audit regime.
again, most things in tax.
Based on your specific circumstance.
So check with your tax professional.
Or if you're a tax professional,
you should know that this is going
to be different for everyone.
But what this allowed, a partnership
to make changes and pay tax on those
changes at the partnership level.
If there was an error
or change discovered.
Because otherwise, right?
Like if a partnership had.
500 partners.
Something is wrong.
It needs to be changed in the partnership.
Every one of those 500
partners gets a new K one.
That means they also have to all
change their personal tax returns and
amend their personal returns also.
So that's where this came into play.
And when that happens.
The change happens at the partnership
level, the partnership pays the tax.
There can be some downside to this,
because if it was at the partnership
level, based on the highest rate that
they could put their, well, there
might be partners whose tax rate
personally would have been much lower.
So effectively they're paying
more tax than they would of.
But as a, as a starting point.
Most small partnerships.
If you qualify to elect
out of this treatment.
There's a good chance that
that's what you'll want to do.
Because if you did not elect out of this,
you can't use that late file relief.
If you did not elect out of this,
you can't amend your return.
So if you find something wrong in a
prior year partnership tax return.
It can't just be amended
the same as always.
There's an entirely different form.
There's a entirely different procedure
for submitting for this change.
And then it happens at
the partnership level.
So talk to your professional.
See if that's what's best
for you, but ask about this.
If you have a partnership tax return.
Ask your tax professional.
If they elected out.
Of this centralized
partnership audit regime.
So you are allowed to elect out.
As long as a few criteria are met.
The partnership has to have
less than a hundred partners.
And they have to all be eligible partners.
An eligible partner
includes an individual.
A C Corp or a foreign entity
that would be a C Corp.
If it was domestic.
An S corporation.
Or the estates of deceased partners.
If those are the only types
of partners in the partnership
and there's a hundred or less.
You have the option to elect
out of that whole treatment?
And keep it so that you can still
a men tax returns if you want.
The partnership tax returns.
And then if there's an issue or something
found you would amend the partnership
return and all the partners would
amend their personal returns and pay
their own difference in tax personally.
At each person's separate tax rate.
Ineligible partners.
So if the partnership has
any partners that are from
this list, you can't opt out.
You are subject to that centralized
partnership audit regime.
No matter what, if you have any of these
type of partners, so ineligible partners.
Are going to include other partnerships.
He trusts.
Foreign entities that would not be
treated as a C Corp if they were domestic.
Disregarded entities and states have
individuals other than deceased.
Partners.
Oh, so why do I mention this as well?
Because there are a lot of legal firms.
That liked to set up elaborate
partnership structures that include
many of these ineligible partner types.
So it is really common to have
a partnership where one of the
partners is another partnership.
We have a tiered partnership.
Or a disregarded entity.
You have an LLC under a partnership
or a trust under a partnership.
This is very common.
So I'm not saying it's right or wrong.
I'm just saying if your attorney suggests
that, or if this is part of your structure
is a partnership with a partner that is.
A partnership, a trust
or a disregarded entity.
Make sure you also understand the tax
implications and the filing implications
of not being able to elect out of that
centralized partnership audit regime.
So in conclusion, Accidental
partnerships happen pretty often.
They're pretty common.
And there are several solutions
for how you can fix them.
And that might work for you.
So to go through and recap
these solutions real quick.
The first option.
Is that if any community property, state.
And the only members of that multi-member
LLC are the taxpayer and spouse.
They have the option under rev proc 2002
69 to be treated as disregarded instead.
The next solution is that if a partnership
was created because two or more people
are carrying on an active trader
business together, your solutions here.
R that if it was only to own
a piece of property for rent,
You do not have a partnership.
Or if the only people operating that
trader business are a taxpayer and
spouse, then they have the option to
instead file as a qualified joint venture.
Where they each just report
a business on the 10 40.
They don't have to file
a partnership return.
Your last solutions are,
if you do have to file.
You do have a late 10 65, you
found out about it after the fact.
Look into rev proc 84 dash 35.
To see if you qualify for late relief
for submitting that 10 65 late.
And kind of the bonus item.
'cause you can't qualify
for rev proc 84 35.
If you can't.
Elect out of this.
Is take a look at that CPAR, that
centralized partnership audit regime
and see if you have elected out of it.
Or not, or if you can, based on
what type of partners do you have.
So in short partnerships
are in a bad thing.
There's lots of reasons to
intentionally create them.
It just happens accidentally pretty often.
If you have a partnership tax
return, it is due by March 15th.
And you can still file
a six month extension.
A partnership tax return does require
quite a bit of more information.
So you will probably need
additional bookkeeping.
And you're going to have to pay
for a second tax return as well
as separate 10 65 tax return.
So think about this as well.
When setting up your structure, or
when talking to attorneys about your
legal structure and how it's going
to help you on the protection side.
Because this can add up pretty quickly.
Unintentionally.
So I'll leave off today's
episode with a quick story.
Of something I saw this week on Facebook.
So someone posted in a group,
a real estate investor group,
and they said, I just got the
bill for having my taxes done.
And it's going to be like $12,000.
This is crazy.
Like we have six rental properties.
We have six LLC is like, this is madness.
There's nothing too complicated about it.
People are all over the place, right?
Like that's ridiculous.
You're getting ripped off.
That's crazy.
I can't believe that much.
But we ask a few more questions.
Guess what?
They had set up every LLC in
every single LLC held one rental.
Every single LLC was an LLC owned
by both the taxpayer and the spouse.
So every single rental had
its own partnership return.
If you want to file your own
partnership return on TurboTax.
I think they charge like $1,200
for you to do it yourself.
So if you're going to go to a tax firm
with six partnerships, Paying 12 grand,
which is, you know, two grand or return
plus their personal, that's not out
of the realm of a reasonable price.
It's that these taxpayers didn't realize.
They had accidentally created
a half dozen partnerships.
Additionally since they didn't
know that's what happened.
I'm guessing they also didn't have
really good books and tracking
to do a partnership either.
So that tax firm probably had to put a
fair amount of time into some bookkeeping
to kind of pull together that information.
So that's kind of, my morning story
is accidental partnerships happen.
Try to prevent it.
If you have two or more people
on an LLC, it is almost always
going to create a partnership.
Or if you are just operating an
active business with another person.
It is likely going to
create a partnership.
I hope some of these
solutions are helpful for you.
So as always, I am so thankful
to you guys for listening.
Please make sure if you found some value
in this episode, or if you're sitting
there and thinking of the person you
accidentally created a partnership with,
please share this episode with them.
Share it like it.
Give us a follow.
And if you are a tax professional, please
join us in the online Facebook group.
If you're a real estate investor, I've got
a separate group for real estate investors
links to everything are in the show notes.
Thanks so much for listening and
I will talk to you guys next week.