What Tax Entity Should A Husband-Wife Team Pick To Do Real Estate Investing?
Nothing in this hub is tax or legal advice. Please consult with a professional. The following is for information, educational, and entertainment purposes only.
We’re a newly-wed husband wife team trying to escape the rat race through real estate investing. We’ve made mistakes, but we’ve also had wins. We’re far from achieving our goal of financial freedom but are getting closer every day. This hub is about how a husband and wife team owning and renting real estate may want to elect how they want to be taxed. This is key because however you decide to be taxed will compound over a number of years. To illustrate: President Obama this week noted that financial advisors who charge just 1% extra in commissions end up costing their customers up to a third of their entire life savings over a lifetime. That’s how powerful time can be. So make sure you choose wisely.
Partnership? Some Drawbacks
Generally, the default rule is for a husband and wife team to be taxed as a partnership. Defaults are dangerous because they are rarely set up to benefit you. This is because whoever sets up the choice architecture is counting on human nature to be lazy. For example, have you ever bought a $900 TV with a $100 rebate? You probably bought it and in your head you were paying $800 ($900-$100). But when you got home (watching House of Cards), you may have forgotten to mail in the rebate, so the manufacturer ended up pocketing that $100. The default was a $900 TV, but getting the better deal required you to act. Likewise, the default tax election is partnership, but getting the better deal may require you to act.
A partnership requires you to file a whole bunch of forms which are very complicated and time-consuming. You would probably need an accountant, and because the forms are so complicated, the accountant can cost you a fair bit. For example, you would have to file Form 1065 which is called the Return of Partnership Income. On this form, you must report income, deductions, gains, and losses related to the partnership. Next, you and your spouse each would need to file a Schedule K-1, itemizing each spouse’s portion of the income (or loss). Then, you need to file a Schedule E, which is known as the Supplemental Income or Loss form, for each partner. Then, you need to fill out the Schedule SE (for self employment income). All that work, only to then consolidate the data onto a joint Form 1040 (we are assuming that you – like us – would need to file a married, filing jointly return). That’s the power of the default rule – being lazy early on causes tons of work on the back end. Don’t do it.
Some couples avoid the morass of having to file all the partnership paperwork by essentially putting everything into one spouse’s name so that the business can be treated as a sole proprietorship, which is much simpler to handle. We think this is risky on several levels. First, by only having one spouse on paper as the owner of the business, you may eliminate certain deductions that the non-listed spouse may incur. And if you have a strong marriage, which we hope you do, it’s unlikely that one partner is totally uninvolved. Second, in the (hopefully unlikely) event of divorce or separation, it may be messy. We’re romantics, but in this area we want you to be realistic as well. Third, you may risk losing an audit by the Social Security Administration or the IRS if they find you are both functionally equal partners – spouses as a common-sense matter are typically presumed to be teammates. And in that event, you end up spending more money filing amended returns or reconstructing whatever it was you have been doing for the past several years. Do it right.
Qualified Joint Venture
There is a third option you should consider: You can elect to be treated as a Qualified Joint Venture. The IRS defines requires for this election that: (a) the only members are a husband and wife filing jointly; (b) both spouses must materially participate in the trade or business (passive co-ownership does not count)—so keep track of your time (500 or more hours during a year should be ok); (c) both spouses must elect not to be treated as a partnership. And, you cannot be a state law entity, but use your own names. You would file a joint tax return, and the husband or wife each would need to file a Schedule C and SE. Make sure you split income, gain, loss, deduction, and credit according to your contribution (typically for most spouses this is half and half). And according to the IRS, spouses with a rental real estate business not otherwise subject to self-employment tax must check the box on Line 1 of Schedule C and should not file Schedules SE. Please note though, that the qualified joint venture does not allow you to use an EIN or operate under an LLC—which may expose you to legal liability in other contexts. So make sure you think about the election first, but it may be worth it for you.
Both of us have only been on this path to real estate investing and financial freedom for about eight months. We grew up in immigrant households with no financial literacy, and sometime struggling through these issues is very difficult. We feel like we never learned a language that others grew up with, but we are taking steps to change that. It used to be that we filed our tax returns in about half an hour because all we had was our salaried income (which is taxed at a high rate as compared to capital gains or other income). We are on this journey together to build something sustainable. And as part of that, we are have to grapple with issues such as what tax treatment to choose. Make sure you give much thought about this and think of taxes as a tool to help you build wealth in the long run.