4-plex, 2 Owners, Many Questions
I really appreciate all the great information on this forum. Though I've read most of the posts here, pub. 527, and a couple of tax books, I'm still not sure how to handle the following scenario:
A friend and I are closing on a 4-plex next week. We will each own 50%. I will be living in one of the units, my friend will not. The units are each about the same square footage.
1. How do we allocate expenses such as repair costs? Can they be split any way we choose? Since we can only deduct expenses on the 3 units I'm not living in, can I give my friend 75% of these expenses, and only take 25% myself? Or do we have to split the expenses 50/50?
2. For mortgage interest deductions, would it be acceptable to apply 25% to my Sch. A, 25% to my Sch. E, then 50% to my friend's Sch. E?
3. How do we allocate depreciation? Can we just go 50/50 on our Sch. Es?
4. If we replace the roof, how do we capitalize the expense?
Thank you for any help,
Steve[ Edited by lostinplace on Date 12/12/2003 ]
How do you own 50%? ( How are you taking title?)
In any case, You should pay fair market rent to the entity and treat it like a business.
If you each own one half interest, you split things the way you want to split them. You are actually renting from the entity.
Gregg
_________________
Gregg Fous
Investor/Developer
"Developers Make it Happen"[ Edited by GFous on Date 12/12/2003 ]
Be careful you don't damage your friendship. My sugestions:
1. Form an LLC that spells out all the details, and have a WRITTEN agreement on everything.
2. IMO you are responsible for 50% of all expenses if you own 50% of the property. Occupancy should not matter here.
3. The partner gets 75% of the cash flow as he is not getting a benefit from living there and you are.
4. Ask your accountant about capitalization.
Be VERY careful or your friend won't be a friend for long. You will be suprised how fast a friendship can hit the comode when business is involved. I NEVER invest with friends for just that reason.
Goodluck.
One more thing, you can deduct the expenses for all 4 units as you are actually renting from your LLC.
Thanks for the replies. The advisory about doing business with friends is well-taken. We are planning on holding title as tenants in common, and will probably form an LLC. Next week we will be meeting with a CPA, but I would like to understand as many issues as possible before the meeting.
For the sake of argument, say we don't form an LLC, and that rent on all units is $1000/mo.
1. Should I pay $1000 (to whom?) and then my partner should receive 75% of income? If income is $4000/mo, it seems like we both should receive $2000. If I get the value of living in the building ($1000), should I receive $1000 from the other rents and my friend $2000?
2. Is it acceptable not to split expenses 50/50? Does the income split have to correspond to the expense split?
3. If I'm living in 25% of the building, and we can't deduct expenses for that part of the property, does this mean we can only capitalize 75% of the cost of a new roof?
Any advice or information is appreciated- thanks.
Steve
placed in an entity it would be like you were not there at all. YOu would treat it like any other business with income and expenses to be split 50/50 or however your partnership agrees.
you would pay$ into the business and then both pull out in equal measure if you are a 50/50 partnership
[addsig]
Thanks for the reply, Stockpro99. I think I understand how things would work if we formed an LLC, and we are planning to form one. But I'm trying to figure out how things would be done if we don't.
Yesterday I spoke with an IRS rep and still couldn't get the answers I was seeking. One thing seems to be clear: If I live in the building, then that portion of the building's expenses cannot be deducted.
When I brought up capitalizing improvements like a new roof, the rep could not tell me exactly how to allocate the depreciation. She first stated that I could depreciate the total cost between my friend and myself. Then she brought on someone else who told me that if I was living in the building, the expenses for that part of the property could not be deducted. Therefore, I could not depreciate the full cost.
The first rep came back and said that didn't seem right. At that point my lunch break was over and I couldn't wait for the third rep to come on the line.
Sorry for the long post, and I don't mean to beat a dead horse here, but if anyone can shed some light on this I'd be really grateful.
lostinplace,
Given the following facts:The property is a four-plex comprised of four units of equal value and amenities.
You and your "partner" each own half (50%) of the property.
You will occupy one unit as your primary residence.
Let's also make the following assumptions:You and your partner agree to share equally all the expenses, management, and income from the property as if the four units were income producing rentals.
Since the four units are essentially equal, all the units will have the same market rent.You and your partner both agree that your occupancy and use of one of the units will not disadvantage your partner.
Now, let's pretend to divide the four units between the two of you. If all four units are fully rented, each of you would be entitled to the income from two of the units. Each of you would equally share the expenses of ownership.
Therefore each of you contributes 50% of the mortgage payment, property taxes, utility costs (if you only have a single meter for water, gas, electric), trash removal fees, etc.
As a consequence, your partner receives the rental income from two units less his share of the overhead expenses.
Because you are occupying one of the units and not contributing rent, you would only be entitled to the rental income from one of the units less your half of the operating expenses. This means that your partner really gets only two thirds (66.66%) of the NET cash flow and you get the remaining third.
Your partner's Schedule E would show his share of the rental income, operating expenses, and half of the depreciation expense.
Your Schedule E would show your share of the rental income, but only one-fourth of the depreciation expense (you can not depreciate your personal residence), and one-fourth of the mortgage interest and property taxes. While you will pay one-half of the total operating expenses, you will only deduct one-fourth of the total operating expenses on your Schedule E.
On your Schedule A (if you itemize), you would also deduct one-fourth of the mortgage interest and property taxes because these are allowed deductions for your personal residence. The other fourth of your operating expenses (such as snow removal, trash removal, common utilities, etc.) are personal expenses and not deductible. Because the cost of repairs and maintenance in your residence unit are not deductible and should not disadvantage your partner, you should pay for these items out of pocket.
If a capital improvement comes along, such as a new common roof, then your partner capitalizes his half of improvement on his Schedule E. The other half -- your half -- is divided into two parts. The first half of your share is allocated to your rental unit and depreciated on your Schedule E. The other half of your share is allocated to your residence unit and added to your cost basis for your residence use share of the property.
Hope this helps.
Dave,
I truly appreciate your detailed response. This is exactly the information I was looking for, and your explanation was crystal clear.
Thank you very much.
Steve
Hi Dave,
One follow-up question:
The 3 rented units in this 4-plex need repair work. There is also general building maintenance required. If my friend and I agree that I will be compensated for this work with free rent, can we then split the income from the 3 units 50/50, not 66.7/33.3, and allocate the expenses as you previously described? If this is possible, are there any other tax issues?
Thanks very much
Steve
I assume from your question that you have not actually bought the property yet.
If this is the case, then purchase the property and rehab all four units to the same standard. So far, this is a straight business venture, and each of you share equally the cost of the acquisition and the rehab. The rehab costs are not expensed, instead they increase the cost basis for the property.
Once the rehab is done, and you are ready to place the property in service, proceed with your plan to use one unit as your primary residence and to share the income and expenses from the remaining units on a mutually agreeable basis (such as I had outlined previously).
The increase in the cost basis (from your rehab) gives you a little better depreciation expense on your Schedule E, and gives you a higher cost basis (lower capital gains) on your residence unit when you sell the property.
A licensed tax professional can guide you through all of the tax ramifications of any scenario you might propose. I would also suggest you use a good attorney to draft a partnership agreement between you and your partner.
Dave,
I appreciate your feedback, and apologize for not explaining things completely.
We are due to close on December 19. The repairs and maintenance needed are not, from what I understand, considered rehab or improvements. The repairs involve things like caulking windows, fixing leaks, weatherstripping, fixing door and cabinet hinges, etc. The maintenance is cleaning around the property, and taking care of the landscaping and laundry room.
Given this, would the plan I proposed be acceptable if my partner and I agreed to it?
We are meeting with a CPA this week, and we have an attorney, who has handled other work for us, to draw up the agreement. I'm just trying to gather as much knowledge as possible so I'll be able to discuss the issues more intelligently.
Thanks very much,
Steve
If I am participating in this deal with you, I would proceed with the purchase and repairs on a 50-50 share basis as if all four units are to be rented. The general building maintenance may still be a capital expense and should also be shared equally. Address this with the CPA.
If I were your partner in this deal, then I would tell you that you are entitled to the rental income from two units, and I am entitled to the rental income from the other two. If you want to use one unit as your personal residence -- rent free -- then it comes out of your share. A 50-50 split of the income from three units means I get less income than I am entitled to, and you get more than you should get from just one rental unit in service. If I were going to be your "partner" in this deal, under the arrangement you suggest, I would just tell you to step aside and let me do the entire deal by myself. If you still want to live in one of the units, you become a tenant just like the other three tenants in the building, or,
stay in the partnership on a 50-50 basis and just rent the unit from the partnership with an arms length lease agreement, or,
identify which two units each of you will take. Each of you separately operate and manage your own units and deal with repairs, maintenance, and vacancy for your own units. You will still share the mortgage payment, building insurance, and property taxes on a 50-50 basis. The building and grounds will be treated as a common element with all costs of building and grounds maintenance to be shared equally. Utilities will also be considered a common element unless each unit is separately metered. If separately metered, then each partner pays the utility costs for only his own units. If you want to live in one of your units instead of renting to a tenant, then that is your business and does not affect the other partner's income from his units.Just me talking here. You should be having this conversation with your partner. No one on this board can tell you what arrangement your partner will accept.
Of course, any allocation of income and expenses in your partnership is possible, but only if you both reach mutual agreement. This is why I tell you to have an attorney draft a partnership agreement for the both of you. The agreement would clearly describe the responsibilities and role of each partner, as well as the ratios you use to prorate the cost and income sharing. The agreement should also stipulate the ratios you will use when you decide to vacate your unit and convert it to rental use. [ Edited by DaveT on Date 12/14/2003 ]
Dave,
Once again, your comments are much appreciated. I realize how difficult it must be to respond to questions with only partial information. From my side, it's hard to know how much detail to go into, as I don't want to ask anyone to read more than necessary.
The arrangement I described was proposed by my partner. We have been friends for more than 25 years and have a few investments together. While the proposal may seem tilted in my favor, there are reasons for this compensation that we both agree on- in fact, my friend strongly prefers this arrangement to the others we considered. I was just trying to find out if what we were planning was acceptable from a tax standpoint. From your post, I gather that it is.
Dave, I've been reading your posts in this and other forums, and I just want to say that I think your contributions are extraordinary. You've opened my eyes to many aspects of this situation, and various other issues as well.
Thank you,
Steve