When you own investment real estate with another person, what do you have? Do you have a partnership that owns the real estate or is the real estate your separate property which you may do with as you please, subject only to rules embodied in a multi-owner agreement? What does it matter, you ask? The answer to that question is discussed below.
Why Does It Matter?
It matters because you may be bound by an ownership arrangement that benefits the IRS, not your investment objectives. The “tax tail” should not wag the dog; however, the financial and tax consequences of a multi-owner investment must be known to all owners before the investment is acquired. You and the other investors agreeing to how your joint ownership will be characterized for Florida and federal tax purposes is one of the basic elements to the successful start of a multi-owner real estate investment. Actions matter and so do the words within the agreement you sign when you acquire your interest in the investment asset. Before you can be ready to agree or negotiate with the other potential owners, talk alone with your attorney about the proposed form of ownership, describe your financial objectives in that discussion and discuss your expectations of how the owners will interact with one another. Then, you have the background to make an informed decision based on what is best for your overall objectives in acquiring the real estate investment.
Getting Real With Your Real Estate Investment
Let’s say the background between the owners of the investment real estate leads the IRS to conclude that a partnership exists. While you thought the owners’ separate interests would be a tenancy in common, where you own your property apart from the others with no right of survivorship at a death of an owner. Is that important? It sure is if your investment objective is to hold the property for five years, sell it, and invest the net proceeds to acquire replacement property in what is called a like-kind exchange. If each owner, as far as the IRS is concerned, is a partner and not a tenant in common, that will defeat your business objective because the sale of the investment real estate owned by a partnership does not qualify as a like-kind exchange. You should be aware of what the IRS will consider in order to conclude that your undivided interest in the investment real estate qualifies as “relinquished” property under the like-kind exchange rules.
Will your multi-owner investment real estate be considered as a tenancy in common for tax purposes?
There is not one all-encompassing “black-letter” rule to determine how the ownership of investment real estate is characterized for tax purposes. There are, however, observable facts the IRS will consider in making its determination. Foremost is to have a written multi-ownership agreement associated with the investment real estate that includes:
- A statement that the owners intend to own their respective interests in the investment real estate as a tenant in common;
- The owners are not members of a business, partnership, trust, or other legal entity;
- How funding the purchase will include using the real estate as collateral, assuming the purchase is not an all cash transaction;
- The mortgage applies to all of the real estate;
- The expenses of the loan for lender’s fees, transfer taxes, title insurance premiums, CPA and attorney fees will be shared in proportion to each owner’s interest in the investment real estate;
- Each owner will share the debt in proportion to that owner’s interest in the real estate;
- The agreement would apply to the real estate and control how the real estate ownership will continue to be a tenancy in common;
- Representations that the owners will not file a partnership or corporation tax return, operate a business under a single name, or join in a subsequent agreement amending the multi-owner agreement without the written consent of all owners; and
- The owners will only act together to maintain, repair, and lease the investment real estate.
Remember that even if Florida law does not recognize the relationship of the owners as a partnership and concludes ownership resides in the names of the individual owners as a tenancy in common, the IRS will apply federal law, not Florida’s law, to make its determination. The IRS sees a partnership when the relationship between the owners is a joint venture or other organization in which business, a financial operation or other venture is operated and is not a corporation, trust or estate under federal rules. The IRS may conclude that an undivided interest in investment real estate is not an interest in a partnership or another business entity for federal tax purposes when those specifics include: tenancy in common ownership, the number of individual owners, that no acts by the owners or their representatives will relate to the ownership structure as if it was a partnership or other entity, the existence of a multi-ownership agreement, how owners vote, the restrictions when transferring an owner’s interest to a third party, how net proceeds and liabilities of the sale of the real estate are shared, a requirement that debt be shared proportionately, a review of the content of option, management, leasing and loan agreements, and a determination that activities of the owners are not compensation but income that qualifies as rent.
While the discussion above includes important items to consider when choosing between a partnership and a tenancy in common, often the decision will be made for you. If the investment real estate will be the collateral to acquire the property, the lender will probably provide that as a condition of closing and funding the loan, the real estate must be owned by a limited liability company (LLC) that has but one major asset, e.g. a shopping center. A multi-owners’ agreement stating each owner is a tenant in common will rarely be acceptable to a lender.
The attorneys at Stross Law Firm, P. A. are available to discuss the design of your business relationship and how a properly designed business relationship may assist you in attaining your business and estate planning objectives when considering acquiring an interest in Florida investment real estate. To schedule a consultation, give us a call at 813-852-6500.