Real estate investors sometimes purchase rental property with fellow investors to quickly grow a rental property portfolio and to take on larger investment deals, like home portfolios, that a single individual investor could not afford.
Before jointly investing in real estate, it’s important to understand how income (or losses) will be allocated to each investing partner.
To help answer that question, let’s take a look at the different options for investing in real estate with a partner, and how the joint ownership of rental property income works.
- Rental property income includes items such as normal and advance rent payments and landlord expenses paid by the tenant.
- Common options for the joint ownership of rental property are with a spouse, a business partner, or as a member of a company.
- Business entities used to hold real estate, such as an LLC or S Corporation, are known as pass-through entities because income and expenses are passed through to each member or shareholder.
- Schedule K-1 is used to report to each member’s pro rata share of income or losses
- An investor who buy property jointly with someone else may be able to claim all of the rental income, provided that the IRS rules for special allocations are followed.
How to calculate rental income
Before we discuss joint ownership of rental property income, let’s take a quick look at how to calculate income from a rental property. According to IRS Topic No. 414 Rental Income and Expenses, rental income includes:
- Normal rent payments
- Advance rent payments
- Payments for canceling a lease
- Expenses paid by the tenant that belong to the landlord (such as repainting the home)
A refundable security deposit paid by the tenant is not treated as rental income because the deposit is meant to be returned to the tenant when the lease ends. However, if part or all of the security deposit is withheld by the landlord to pay for damage caused by the tenant, the deposit is recorded as income at the time it is withheld.
The IRS notes that most individuals operate on a cash basis, which means that income is reported when it is actually received and expenses are deducted when they are paid.
Accurately tracking income from even one rental property can quickly become complicated, which is why many real estate investors sign up for a free account with Stessa.
Stessa’s financial management software for rental property automates income and expense tracking, and provides investors with personalized recommendations for maximizing profits through smart money management.
Owners of single-family rental homes, small multifamily buildings, and short-term rentals can run numerous reports, such as net cash flow, capital expense, and income statements, to better track and allocate rental income for jointly owned real estate.
Options for joint ownership of rental property
For most smaller real estate investors, joint property ownership occurs in three different ways:
Ownership with a spouse
When a married couple owns a rental property together, rental income and tax deductions are reported using Schedule E (Form 1040), Supplemental Income and Loss.
If the spouses file a joint tax return, income and expenses are not divided between the individuals. However, if the spouses file separate tax returns, income and expenses are divided as if they were business partners.
Ownership with a business partner
If a real estate investor owns a rental property along with one or more other investors, each party reports his or her share of income and expenses on their individual tax return using Schedule E.
Generally speaking, income and expenses are allocated to each investor based on their percentage share of ownership interest. For example, if four investors each owned an equal share of a rental property, each investor would report 25% of the income and 25% of the losses or deductions on their individual tax returns.
Ownership with business entity
Another common option for co-owners of a rental property is through a business entity such as a limited liability company (LLC), Partnership or Limited Partnership, or an S Corporation.
Entities such as these are not taxed on the company level that way that C Corporations are because they are considered pass-through business types. Instead, income or losses from the LLC are passed through to each member using IRS Schedule K-1 (Form 1065).
After preparing its annual tax return, the LLC or S Corp provides a Schedule K-1 to each member detailing the pro rata share of the company’s income or loss attributed to each member or shareholder.
However, income or losses may be allocated based on each member’s ownership interest in the company or in a manner described in the company’s operating agreement.
As the legal resource website Nolo.com explains, most operating agreements provide that a member’s distributive share is in accordance with the member’s ownership share in the company. So, if an investor owns 60% of the company, the investor is allocated with 60% of the income or losses from the company.
Can one owner claim all of the rental income?
An operating agreement for an LLC that owns rental property can also be written in such a way that profits or losses are not allocated according to a member’s ownership interest, which is known as a special allocation.
For example, an LLC member with a high personal income may wish to receive all of the depreciation expense from the rental property held in the LLC but none of the income, while another member in a lower income bracket may prefer to be allocated all of the income.
In situations where income, losses, and profits are not allocated based on each members’ ownership interest, the LLC must follow the IRS rules for special allocations and investors may wish to consult with a certified public accountant, enrolled agent, or other tax professional for advice.
How income from a jointly owned rental property is taxed
Income from a rental property jointly owned by spouses, business partners, or an entity is taxed based on an investor’s federal income bracket. Tax rates for 2021 are 10%, 12%, 22%, 24%, 32%, 35%, or 37%, based on the amount of taxable income.
The way an investor files taxes varies based on how the rental property is jointly owned. Let’s take a look at how to file taxes based on the most common forms of ownership:
Co-ownership with a spouse
When married spouses own a rental property together and file a joint tax return, income and expense deductions are combined. Income and expenses are reported using a single Schedule E, with the amount of total income or loss from the rental property entered on Schedule 1 (Form 1040), and then on Line 8 of Form 1040, 1040-SR, or 1040-NR.
Co-ownership with two or more owners
When a rental property is jointly owned by two or more owners, each owner reports his or her share of income and expenses on Schedule E based on the ownership interest in the property, which are normally included on the property deed.
For example, assume that three family members or business partners own a rental property with a 50% – 25% – 25% split.
The owner with a 50% ownership share would list 50% of the property income and expense deductions on Schedule E and pay tax on that amount, while the remaining two owners would each report 25% of the income and expenses and pay tax on those amounts. Each owner would also use Schedule 1 and the applicable version of Form 1040 to report total personal taxable income.
Co-ownership within a business entity
Real estate investors sometimes form a pass-through business entity or company to hold rental property, for legal and income tax purposes.
However, unlike individual taxpayers, a business entity that holds real estate does not file a Schedule E nor pay taxes at the company level.
Instead, the company files an annual tax form and reports each investor’s share of income and expense deductions using a Schedule K-1. The investor then uses the information provided on the K-1 to prepare a personal tax return and pay income tax.
Learn more about reporting rental income
Here are three helpful resources from the IRS for investors interested in reading more about taxes on residential rental income and real estate income and deductions:
- Know the tax facts about renting out residential property
- Tips on Rental Real Estate Income, Deductions and Recordkeeping
- Topic No. 414 Rental Income and Expenses
The smart software at the Stessa Tax Center also helps to make tax season something to look forward to by helping investors to prepare taxes in three simple steps. After signing up for a free Stessa account, investors have access to a variety of tax resources.
For example, members of the Stessa Community receive an exclusive TurboTax discount, while The Real Estate CPA, a certified public accounting firm that specializes in working with real estate investors, has created a suite of tax resources in partnership with Stessa.