Small Business Taxes & ManagementTM--Copyright 2008, A/N Group, Inc.
A number of readers have asked about this. Just a different name for the same thing? Far from it. If you and another party--your spouse, child, relative, friend, business partner, etc. want to co-own property, both forms can be used. But the legal consequences are very different. If you and a friend own property as joint tenants (technically joint tenancy), the property automatically passes to the survivor on the death of the other party. Good news? You don't need a will. Bad news? A will or living trust won't change the outcome. (That can cause estate tax problems.) And, no matter how many co-owners are involved, it's assumed that each has an equal share. Thus, if Fred, Sue and Dick purchase a rental as joint tenants, each will have a 1/3 share. Finally, in the case of jointly owned property, no owner can sell his or her share without the other parties' consent.
Generally, you must have a written agreement to hold property as joint tenants. That's often done using the phrase "Joint Tenancy with Right of Survivorship". If you don't specify, or don't use the right language, how the ownership will be interpreted may depend on the wording, state law, or the decision of a court. The bad news here is that the issue may not come up until one of the owners dies. Make sure there's no question.
On the other hand, if the property is owned as tenants in common (technically tenancy in common), the ownership shares can be different and each party is considered to own his or her share and can dispose of it as they wish. For example, if Fred puts up 20% of the purchase price, Sue puts up 50% and Dick puts up 30%, that's what their ownership interests will be--20%, 50%, and 30%. Each party can leave his or her shares to any beneficiary on death or sell their interest to any other party without the consent of the other owners (you can modify that by drafting an agreement that puts restrictions on the transfer). Each party can also encumber (borrow on) his or her interest in the property (the rule here varies by state). All parties should keep a record of the expenditures they pay, paying attention to the type of expenditure. That is, whether the funds were used for general upkeep (maintenance, property taxes, etc.) or to pay the mortgage or for capital improvements. Keep in mind that each owner is jointly and severally liable for the mortgage. That means, should the other parties not pay, you can be responsible for the entire amount. What happens if you haven't chosen a form of ownership after purchasing property with another party? In many states, ownership as tenants in common is assumed.
It can get more complicated in community property states. Generally, each spouse is assumed to share in property acquired after the marriage, even if only one is on the title.
There are a number of tax issues with property held in joint tenancy, some of them can have significant adverse consequences. The following applies only to unmarried individuals. First, if you create a joint tenancy by adding someone else's name to the ownership of a property (e.g. putting your son's name on the deed to your vacation home) you may be creating a taxable gift. While there may be no immediate tax consequences if the value of the gift is more than $12,000 (2008 amount) you will have to file a gift tax return. Furthermore, since each joint tenant is presumed to have an equal share, putting your son on the deed would be the same as gifting him half the property. If that's your vacation home, it could be an expensive gift. Second, the rules are different in the case of a bank account. Setting up an account in joint names or adding a name will not create a gift. Only the withdrawal of funds by that individual results in a gift. Third, gifting property by joint tenancy has the disadvantage of all gifts. There will be no step up in basis on your death. On the other hand, any appreciation in the property after the gift will escape estate taxes. This is a tricky area, particularly since the estate and gift tax rules are scheduled to change in 2010. Finally, keep in mind that the IRS presumes that the first tenant to die contributed all the funds to purchase the property. For example, you and your daughter purchase a vacation home, each putting up half and each paying half of the expenses each year. You die several years later. Unless you can prove otherwise, the IRS will assume the entire property is part of your estate. If your daughter can prove her contribution (canceled checks, bank statements, etc.), you can rebut the presumption.
There are several other ways to jointly own property.
The first is called tenancy by the entirety with right of survivorship. It's similar to joint tenancy (the surviving spouse automatically inherits the property on the death of the other spouse), but is only available to married couples, and only about half the states allow it. Some married couples automatically choose this option. But that's not always the best approach.
The second is by setting up a partnership. This is more expensive. You'll have to draft a partnership agreement, file papers with your state, file federal and state tax returns for the partnership, set up a bank account, etc. But there are a number of advantages here. First, your partnership interests can be very different. For example, Fred puts up 30% of the funds to buy the property and Dick puts up 70%. But Fred agrees to manage the property and cover 50% of the maintenance expenses. Fred could have a 30% capital interest (e.g., he gets 30% of the proceeds on the sale), but is entitled to 50% of the profits and losses. In situations like this, a partnership makes particular sense. Second, should Fred decide to leave, he can simply sell his partnership interest without selling the underlying property. That's important if more than one property is involved. (Selling a partnership interest isn't all that simple, but it's easier than dealing with joint ownership.) Because of the cost of dealing with a partnership, it probably doesn't make sense for a vacation home that's not rented for profit, particularly if the parties are relatives. The big disadvantage of a partnership is that the partners are jointly and severally liable for the debts of the partnership. (A limited partnership avoids that problem, but is more complicated. You can also avoid the problem by organizing as an LLC.)
An LLC (limited liability company) is similar to a partnership in that it exists as a separate entity, files tax returns, and is generally taxed as a partnership. The big difference is that LLC owners are generally not responsible for the liabilities of the entity.
You might consider setting up a trust. This approach is very popular way to hold real estate in some states, but it's often not as flexible. It can be a good way of holding real estate for appreciation, or a vacation home or simple rental property. Talk to your accountant or attorney first. There are difference types of trusts and different consequences. Depending on circumstances, the trust may or may not have to file tax returns.
A S corporation is sometimes used as an alternative to a partnership, but it's not the most attractive choice for holding real estate. There is no such thing as separate capital and profits interests. The big advantage is the limited liability for shareholders and ease of transferring ownership (you can simply sell your stock).
In some cases you might consider a family limited partnership. This is really a partnership with special tax advantages for property held in the family. You'll need professional advice on this one. The IRS has been challenging these entities. Family limited partnerships are designed to hold business and investment properties, not your vacation home.
A C corporation can be used for holding and renting property, but there are a number of disadvantages including the double taxation of profits and gains, the inability to currently use losses, etc. That generally makes it a poor choice.
What's the best method? There's no one answer here. Certainly if you're looking at multiple properties, particularly if this is a business venture, a partnership or LLC is an attractive option. The set-up and annual costs are spread over several properties. That's especially true if there's no easy division of profits and losses and sales proceeds, or if one party is providing more or less labor and more or less capital.
No matter what form you select, you may not be able to avoid problems without a side agreement if there's a disgruntled co-owner. Even in an S corporation, a shareholder who owns 20% of the stock may be able to stonewall actions, or transfer shares to someone you don't want as a shareholder. The only solution is a side agreement restricting the sale of shares, a partnership interest, etc. Consider a buy-sell agreement where any co-owner wanting to get out has to sell to the other co-owners at the appraised, book, or other prior agreed-on approach. In the case of joint tenancy, consider a legal agreement on how and when to dissolve the co-ownership.
Get good legal advice before committing. It's a small price to pay to avoid a costly legal battle in the future.
Copyright 2004-2008 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 01/16/08