LLC holding rental house that is used personally

[Strongsilence-CPA]

1. Client's mother gifted a house to her and her brother in 2024. 2. Then, she formed a partnership with the brother (an LLC.) 3. The costs to operate the house flowed through on K-1s. 4. The house is for family use; it is NOT rented to the general public. Are the expenses on Line 1 and Line 2 deductible?  I don't think they are deductible. And, if that is correct, why did they hire a CPA to prepare a 1065?

[Karen_pdx]

The formation of the LLC could be for ease of management & for estate tax reasons. Best case, they engaged an attorney to write an operating agreement that will help the family manage and use the property over the years, maybe even generationally.

The expenses could be partly deductible - i.e. property taxes and potentially interest. Should not be on lines 1& 2, though. Should be on Sch K in the other deductions section. Maintenance & other expenses would be nondeductible if the property is used only personally.  Forming an entity doesn't change the nature of the expenses, which have to follow the use of the property.

If it has property taxes or other federally deductible items to report, then 1065 is required to be filed, but even if not required, could be worth the expense if it forces them to account to each other at least annually for contributions made & expenses incurred, assuming the capital account section is completed.

[BobKamman]

Let me guess, Mom still lives in the house?  But now if she goes to a nursing home, the taxpayers cover the expense while the kids go on a cruise?  Or maybe this is a second home that has been in the family for years.  Too bad they don't get stepped-up basis if they decide to sell after Mom's death.

@Karen_pdx writes that "The formation of the LLC could be for ease of management & for estate tax reasons."  Well, you see how easy it makes management.  As I have noted previously, there are two kinds of state, those like California that have an annual fee for LLC's ($800 in CA, right?) and those that soon might, as Washington cuts off funding.  There's really no way this saves on estate taxes, but that sounds good. 

If they're trying to evade the $10K SALT cap, they can't do it with a properly-prepared K-1.  Since they're not in business, they shouldn't be preparing a 1065 with any amounts on it anyway.  Zero income, zero deductions, attach a statement that says "personal assets only."  Substance over form.  

[BobKamman]

Partnership
A partnership is the relationship between two or more persons
who join to carry on a trade or business, with each person
contributing money, property, labor, or skill and each expecting to
share in the profits and losses of the business whether or not a
formal partnership agreement is made.

Domestic Partnerships
Except as provided below, every domestic partnership must file
Form 1065, unless it neither receives income nor incurs any
expenditures treated as deductions or credits for federal income
tax purposes.

[Karen_pdx]

If mom retains a life estate, the value of the real estate is actually includible in her estate, so there would be a step up for the real estate on mom's death. If so, there's no difference in mom's estate taxes, but the kids know the real estate can't be transferred to someone else (lots of cases of people unduly influencing the elderly to make transfers that undo other estate planning).

But the estate tax savings referred to could be discounts at the death of the kids, since they would own an LLC interest, not a direct interest in real estate. That could mean a discount for lack of marketability, depending on the terms of the operating agreement. It also means if the real estate is in California or any other state different from where the kids reside, they won't have to probate in the state where the real estate is located. LLC interests are personal property taxable in the state of residence of the decedent, even if the LLC owns real estate.

The use of an LLC to own commonly managed assets that could be income producing or at least could appreciate is not all that unusual. The only other option for management of the assets would be a trust, but that doesn't allow the beneficiary any legal right to participate in management decisions, the way an LLC can. 

[Strongsilence-CPA]

Thank you both. 

Best case, they engaged an attorney to write an operating agreement that will help the family manage and use the property over the years, maybe even generationally.

Today I got the facts:

1. Mom gifted house and money to the kids for estate planning. Then the kids formed the LLC/partnership and contributed the house to it.

2.  The Mom rents the house at an arms-length transaction.  I think this is what qualifies them for trade/business treatment.

3. There were no other tenants. 

Active/Passive/Material participation was an issue that arose.

The use of an LLC to own commonly managed assets that could be income producing or at least could appreciate is not all that unusual. 

The estate matters are outside of my tax practice. Thank you for the learning, Karen.

[Strongsilence-CPA]

"Since they're not in business, they shouldn't be preparing a 1065 with any amounts on it anyway.  Zero income, zero deductions, attach a statement that says, "personal assets only."  Substance over form. "

I learned these facts today from the attorney. I think it is a business but I'm curious about your take:  "Son and Daughter are renting the property to their Mother on an arms-length basis with an executed residential lease and fair market value rental price for her part-time use.  Family members also use it occasionally.  In addition, although the property has not yet been rented to anyone other than Mother, it may be, especially if it ends up being vacant too much or maintenance costs become exorbitant."

[BobKamman]

@Karen_pdx But Mom did not retain a life estate.  When we have a paucity of facts, let's not make up too many of our own.  Since when does a trust not allow co-trustees any legal right to participate in management decisions, the way an LLC can?  And they can manufacture a "discount" based on not having 100% ownership of an LLC, but they can manufacture the same discount for sharing ownership with a sibling.  

And, ancillary probate can be avoided just as easily with a trust as with an LLC.  

I wonder if Mom paid capital gains tax on the arm's-length selling price.  Or maybe Dad just died and she has stepped-up basis.  Which now decreases every year that the kids are claiming depreciation.  It's like paying income tax on their inheritance.   

[sjrcpa]

"I wonder if Mom paid capital gains tax on the arm's-length selling price."

No sale. Mom gave it to the kids.

But what a mess has been created.

Properly drafted Trust would have been better - Grantor Trust for income tax purposes and step up on death.

And wouldn't this gift to the kids who put it in an LLC be subject to a Medicaid clawback or whatever it's called? Or are they betting Mom outlives the clawback period?

[BobKamman]

@sjrcpa That's right, the deal was "this is a gift but then I'll keep giving you money and we can call it rent, so no one will see through it as just a scheme we invented to, remind me, what was the purpose of all this anyway?  At my age I just follow what you kids tell me.  Why are you paying tax on that money I keep giving you, anyway?"

Yes, the gift is a concern during the clawback period, which might be changed to forever by the time she reaches the current cutoff.  It's a challenge to figure out what they were trying to accomplish here, but more fun to think about how the Law of Unintended Consequences could catch up with them.  

[Strongsilence-CPA]

"Why are you paying tax on that money I keep giving you, anyway?"

Rental losses will be the norm in the near future, in my view.