MFJ return with rental property LLC in non-community property state

[CFCCPA2]

I have a MFJ client with a rental property LLC (they are both 50/50 owners) in a non-community property state (OK). They file their 1040 in Texas. I understand that because their rental property LLC is in OK, that they will have to file a partnership return. Does this mean that they will have to issue themselves a Schedule K-1 through the LLC? 

[sjrcpa]

"They file their 1040 in Texas"

Meaning they live in Texas? A community property state?

Did they acquire this OK LLC/rental property before they resided in Texas or after they already did?

I don't know if it matters. I don't know much about community property. Throwing the questions out for those who do know.

If a 1065 is required, yes there will be K-1s.

[CFCCPA2]

They do not physically live in Texas, because they are military they are able to elect where their taxes are filed (in line with the military requirements), so they have been doing so in Texas for several years now.

My biggest questions -

1. Because their joint rental property LLC is in Oklahoma (non-community property state), do I have to file their Oklahoma state return as a partnership? If I do, would we just issue themselves K-1s splitting everything 50/50 and then file Form 1065 in Oklahoma for the partnership? Is there anything that the entity itself has to file with the state?

2. Because they file their 1040 federal return in Texas (community property state), am I able to file the LLC as a disregarded entity at the federal level even though the LLC flowing through to their return is operating in Oklahoma as a partnership?

I've never come across this scenario before, but at the end of the day it's my understanding that there shouldn't be a dollar impact either way that I file, but I do want to ensure that I'm filing everything correctly. Any help or input is greatly appreciated!

[BobKamman]

They must have been in Texas at one time, to make the election to consider that state their domicile.  This is frequently the case with military from high-tax states, if they haven't made it to Alaska first.  But community property has nothing to do with how they report the rental income.  Neither does whether it is located in Oklahoma, really.  If for federal purposes you have decided they meet the requirements for a "qualified joint venture," then Oklahoma will go along with that also.  Just to be safe, tell them to buy a Bible with Lee Greenwood lyrics.  

[BobKamman]

Ignore my answer, I figured out this question falls into the category of "how to deal with stupid clients who went to a seminar and were sold an LLC."  No one at the seminar told them the tax consequences of their meaningless maneuver.  My guess is that they are originally from Oklahoma and bought this property while resident there.  But that's just a guess.  If it wasn't community property when they acquired it, it doesn't automatically become that when they move to Texas.  But they can elect that, which might make a difference to IRS.  

Has anyone told them they need a good insurance policy because they're going to get sued as individuals even if they have an LLC?  And for what they spend on 1065 filing, they could probably buy an umbrella policy that will provide a lot more protection.  

[taxmo]

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@BobKamman wrote:

But community property has nothing to do with how they report the rental income.  

It does make a difference.  In a community property state spouses can share a rental property without needing to make it a QJV.  In a community property state that can even apply if the property is in an LLC, they can still elect to disregard the LLC and it's not a partnership or a QJV.  See Rev. Proc. 2002-69 / 2002 C.B. 831).

[taxmo]

(removing this comment, I meant to reply to the main thread instead)

[taxmo · Accepted solution]

My current understanding is that if they are legitimately domiciled in Texas, their joint ownership of an LLC that owns a rental property in a non-community property state can still elect to be treated as a disregarded entity under Rev. Proc. 2002-69.  The Rev. Proc. doesn't address this specific situation, and I'm not aware of any tax court cases that address it either, but the interpretation I've seen is that they each own partnership interest in an LLC, and they're domiciled in a community property state, so the LLC is community property that they can elect to file income from as a disregarded entity.  

So my current understanding is they can just jointly file their Schedule E rental income.  I might recommend that they still change the ownership to a single member LLC to avoid any uncertainty in the future. 

[BobKamman]

Just because their domicile is Texas doesn't mean everything is community property if they owned it originally in a non-community property state (like Oklahoma).  They can now agree it's community property, but you should document that.  There usually are not adverse consequences to such an agreement, but know your client.  

[CFCCPA2]

Thank you, this was my understanding as well and what I was really hoping to confirm but same as you I couldn't find any similar tax court cases. Federally the rental income will be reported on their Schedule E treated as a disregarded entity. For their Oklahoma state return, it will be reported as a partnership.