Three people jointly own a rental property. They inherited it so all 3 are on both the deed and the mortgage. On their taxes they have all been claiming 1/3 of the P&L and depreciation expenses.

They are looking to refinance, and one of the 3 has had loss of income and would probably not qualify for the new loan, so they will refinance with just two of them. Further, the two participating in the refinance will put in different amounts of cash which will be used to pay down the mortgage and pay closing costs.

Say the property is worth $300k and has a mortgage of $250k which will be refinanced to $210k. $45k will have to be put in at closing to pay the loan down and pay closing costs, and one person will put in $35k and another $10k.

So the result will be three people on the deed but two on the mortgage, and possibly different ownership percentages and cost bases for each of the 3. What do they report on their taxes going forward?

So the result will be three people on the deed but two on the mortgage, and possibly different ownership percentages and cost bases for each of the 3. What do they report on their taxes going forward?

The signatures of the CPA and the tax attorney who helped prepare their tax returns?

Tiddman:

It sounds like they have been doing this wrong. The need to open a partnership and distribute the profit / loss / deductions on the K1. That will feed to their individual returns.

I strongly suggest getting a professional involved.

Dusty

It sounds like they have been doing this wrong. The need to open a partnership and distribute the profit / loss / deductions on the K1. That will feed to their individual returns.

I strongly suggest getting a professional involved.

This is getting complicated enough that a legal partnership might be useful. It isn't a requirement

Well thanks for the suggestions. This arrangement has been reviewed by probably 5 or 6 CPA's, H&R block advisers, lawyers, etc. over the years. Some have suggested setting up a partnership and issuing schedule K's, some have not. The advice given is usually contradictory and incomplete. Lenders and loan officers are also familiar with this and have no problem with it (besides the extra paperwork), as it is common to have several people on a mortgage.

Because the property was inherited, ownership transferred directly to the current owners without any partnership or structure. In my experience, trying to put a property into a partnership is complex and expensive. Lenders would treat the loan as a commercial mortgage which would carry a higher rate, shorter term, and higher insurance requirements, to the point that it would not be a feasible rental property with this kind of financing. Partnership accounting is complex and the partnership would probably require its own tax return. This is all for a small investment property so the overhead would be significant.

I find the advice here to be at least as good, if not much much better, than what I get from the random CPA, which is why I asked here :-).

What do they report on their taxes going forward?

That depends.

What is the new agreement (after the refi) on how the monthly/annual profits and losses are to be split? IOW - if at the end of the year the rental made money, who gets the money? Or if at the end of the year the rental lost money, how is that loss going to be financed?

Further, how are the sale proceeds going to be split when the property is ultimately sold?

The basic idea is that the tax treatment needs to follow the economic treatment - what is actually happening.

So if you can tell me how the profits - both the operating profits and the profits at sale - are split, I can tell you how to report things on your tax return.

--Peter

The advice given is usually contradictory and incomplete.

Let's ask one more question.

Do you want to know how to treat your arrangement for tax purposes, or are you really more interested in ideas on how to make this situation fair for the three parties involved?

OK - that's really two questions disguised as a single question. But does that really matter? Did I just ask another question? I'm up to four now, aren't I? Make that five. Three of which are rhetorical. Do you agree? Is there an end to the questions? :-)

--Peter

PS - Yes, I am a random CPA. So please don't expect anything better than your previous advice. That way you won't be disappointed. ;-)

Tiddman: "Three people jointly own a rental property. They inherited it so all 3 are on both the deed and the mortgage. On their taxes they have all been claiming 1/3 of the P&L and depreciation expenses."

Ok.

"They are looking to refinance, and one of the 3 has had loss of income and would probably not qualify for the new loan, so they will refinance with just two of them. Further, the two participating in the refinance will put in different amounts of cash which will be used to pay down the mortgage and pay closing costs."

Ok.

"Say the property is worth $300k and has a mortgage of $250k which will be refinanced to $210k. $45k will have to be put in at closing to pay the loan down and pay closing costs, and one person will put in $35k and another $10k."

Ok.

"So the result will be three people on the deed but two on the mortgage, and possibly different ownership percentages and cost bases for each of the 3."

I cannot answer your tax questions, but you have some assumptions in your question that I believe are not correct.

I assume that each one inherited an undivided 1/3 interest in the property and that there have been no subsequent conveyances to change that arrangement.

I further assume that you mean two on the mortgage note and all three on the mortgage. Or are you stating the the new lender will be satisfied with a lien on an undivided 2/3rds interest in the property?

Why would ownership percentages change? You did not mention any conveyances among the owners.

And why would cost bases be so different. As I understand the rules, principal paydown does not change the basis of an owner. "Closing costs" covers a wide array of costs, so of which do not affect basis and some of which might affect basis.

In addition to Peter's questions, what arrangements are the owners intending to make? It is not at all clear to me what the owner intend or desire.

Regards, JAFO

Say the property is worth $300k and has a mortgage of $250k which will be refinanced to $210k. $45k will have to be put in at closing to pay the loan down and pay closing costs, and one person will put in $35k and another $10k.

An unsolicted comment,

Have they considered just selling? Your numbers are generic, but imply that there is around 15% equity in the property.

The refinance will complicate handling of the property. One owner has had a significant reduction in income. Is the loss of income the reason they don't want to include his name on the mortgage application or is it because they have a problem with their credit score? The second owner is also weak financially. What if they can't obtain a mortgage in just two of the three property owners names?

I helped an elderly relative with managing an inherited properties that was split between her and a SIL. With even interest in the properties, management wasn't that difficult. A partnership would only have complicated the management. Sale of the property was forced when the SIL passed away.

What is the new agreement (after the refi) on how the monthly/annual profits and losses are to be split? IOW - if at the end of the year the rental made money, who gets the money? Or if at the end of the year the rental lost money, how is that loss going to be financed?

The short answer is that there is no such agreement (yet?). If the answers to these questions are ambiguous without such an agreement, maybe there needs to be one, but that is what I am trying to figure out, if the economics follow the ownership and/or invested capital somehow.

Further, how are the sale proceeds going to be split when the property is ultimately sold?

That is another good question. To me the simplest and fairest approach would be that each party is "made whole" by the proceeds (assuming there are enough) then the remainder (if any) is split 3 ways, but this is probably another good topic for a written agreement.

Do you want to know how to treat your arrangement for tax purposes, or are you really more interested in ideas on how to make this situation fair for the three parties involved?

Well you have once again hit the nail on the head. As you infer, this is a contemplated transaction that makes a lot of sense economically, but before committing, each party is trying to understand the tax implications, which might affect their interest in the deal.

Did I just ask another question?

Sometimes the best answer is a good question :-)

I am a random CPA.

You are anything but random, and I have been indebted by your advice for many years. Thank you for your attention to this question.

I assume that each one inherited an undivided 1/3 interest in the property and that there have been no subsequent conveyances to change that arrangement.

Yup.

I further assume that you mean two on the mortgage note and all three on the mortgage. Or are you stating the the new lender will be satisfied with a lien on an undivided 2/3rds interest in the property?

Well the lender is okay with 1, 2 or 3 of the parties being on the new mortgage, as long as their underwriting guidelines (i.e. debt ratios etc) are good, which leads to this question(s). The lender doesn't care about each person's tax situation after the transaction, but they do. I suspect that the lender holds each person wholly responsible for the entire property and mortgage regardless of the splits.

Why would ownership percentages change?

Well this is part of the question. Is ownership determined by ownership of the property, or participation in the mortgage? Can you have a property owned by 3 people but with only two on the mortgage? That seems strange because one person would have an unencumbered interest in the property, while two would be responsible for a mortgage on the whole property but only hold 2/3 of the property between them.

And why would cost bases be so different. As I understand the rules, principal paydown does not change the basis of an owner. "Closing costs" covers a wide array of costs, so of which do not affect basis and some of which might affect basis.

This is my thought too, with the caveat that some costs of a mortgage refi can be added to the cost basis. If some but not all parties participate in the refi, then only some might have their basis adjusted.

In addition to Peter's questions, what arrangements are the owners intending to make? It is not at all clear to me what the owner intend or desire.

Well it is kind of a chicken and egg thing, everyone is trying to understand the economics and tax consequences before agreeing to terms.

Have they considered just selling?

I guess the short answer is yes, though clearly this is not the market for selling properties, and is the market for refinancing them. Even without much equity, a rental property financed at 3-4% provides attractive returns. Comparing putting cash into a rented property to cut the interest expense in half vs. buying a new property or other investment options makes this look interesting.

The refinance will complicate handling of the property. One owner has had a significant reduction in income. Is the loss of income the reason they don't want to include his name on the mortgage application or is it because they have a problem with their credit score? The second owner is also weak financially. What if they can't obtain a mortgage in just two of the three property owners names?

Without getting too far into the details, two of the owners are strong financially and either one could probably carry the mortgage by themselves without a problem. One desires to commit less capital to this deal, yet they still wish to partner in order to share the load and the returns.

I helped an elderly relative with managing an inherited properties that was split between her and a SIL. With even interest in the properties, management wasn't that difficult. A partnership would only have complicated the management. Sale of the property was forced when the SIL passed away.

I would think that this kind of thing happens fairly often. Properties are often inherited, often by more than one person, and usually some of those people have more interest and money to invest than others. These kinds of arrangements are common in commercial real estate joint ventures for example. Despite some apparent complexity, it seems that this should be ground well trodden.

I know someone whose grandmother passed and the house was inherited by 19 people (kids, grandkids, etc). Nobody wanted to live in it and pay rent to the other 18, yet nobody wanted to give up their interest in "grandma's house". So they found a tenant, and were left stuck figuring out how to split up the ownership and P&L among 19 people. This is the same kind of situation I am describing. I would think that this kind of thig happens all the time.

This is the same kind of situation I am describing. I would think that this kind of thig happens all the time.

More often at least one of the parties wants the cash and not the property.

In a title situation, I have never known a lender who would not want all the property owners sign the mortgage. Now, the note is another subject altogether. Any one or all of the owners may sign the note; however, they will be responsible for the payment of the note. The mortgage merely securitizes the note.

Donna

OK - so we're trying to structure the transaction ahead of time rather than figure out what has already happened. Good.

Offhand, I can think of two ways to work this to make things reasonably fair. There's likely more, but it's late and the advice is free. ;-)


One way is to think of everyone as having their own separate rental property. So each person has a $100k property with an $83.3k mortgage. (That's 1/3 of the 300k property and 250k mortgage.) Now all three refinance at the same time.

One does a straight refi, rolling the refi costs into the loan. So now his loan is $85k. (That's the original 83.3k plus 1/3 of the $5k in closing costs.)

The second puts $10k in to pay costs and reduce the loan balance. Her loan is the original 83.3k plus 1.7k in costs less 10k, or $75k. Similarly, the third puts $35k in and ends up with a $50k loan.

So the three loans amount to 85 + 75 + 50 which is the 210 you specified in the OP.

Each year, then, you'd split all the income and the costs 1/3 each except for the mortgage interest. That would be split 85/210 (or about 40.5%) 75/210 (about 35.7%) and 50/210 (about 23.8%). Any cash profits would follow similarly. Decide on the cash available to distribute, then add back the total mortgage interest for the period (year, month, quarter, whatever). Divide that by 3, then charge each person with their correct share of the mortgage interest. You should end up with the person who put the 35k in to the refi getting more cash than the person who put nothing in to the refi.

When you sell the property, you'd split the sale price and all the selling costs 1/3 each - after all, you are all still 1/3 owners. But you'd have to do a little tap dance to figure out the split of the cash. Take the cash available, add in the mortgage balance that was paid off, then charge each person with their share (the 40.5%, 35.7%, and 23.8%) of the mortgage balance. The person who put nothing in to the refi will get less than the other two.



Another approach would be to look at the equity in the property before and after the refi.

Before the refi, everyone has $16.7k of equity. One-third of the $50k total equity. After the refi, the one who put nothing in has $16.7k less $1.7k (for their share of the refi costs), or $15k of equity. The person putting $10k in will have $25k of equity, and the person putting $35k in will have $50k of equity. The math still works, 300 of value less 210 loan is 90 of equity, which is the total of 15 + 25 + 50.

That makes the ownership shares 50/90 (55.6%), 25/90 (27.8%), and 15/90 (16.6%). The person putting in the $35k is buying part of the property from the other two owners.

The immediate result is that the two selling owners would need to recognize any gain on the partial sale of the property. (Losses would probably not be recognized due to related party issues.)

The up side is that everything is now split based on the new ownership percentages. There's no need to fiddle around allocating one expense differently from all of the other items. It would be a one-time adjustment to the ownership, then everything continues on based on the new ownership split.


You could probably tweak these in multiple ways to get the desired result. (One I can think of would be to engage in a bit of algebra to split the refi costs based on the "after" ownership of the loan or property rather than the 1/3 each "before" ownership.) And there may be other ways to slice and dice things. I'm sure that other creative types could come up with other solutions.

The key is to do what I think you're doing - talk this out among the three of you and come to your own decisions. Because things are going to become unequal, I'd highly recommend putting the agreement to writing. You don't need to spend thousands of dollars on an attorney to do this, just get it all down to a piece of paper so that everyone can see it and agree to it. I suspect a google search of "co-ownership agreement" or "joint ownership contract" or something similar would turn up some suitable samples you could tweak for your needs.

--Peter

PS - Here's one more idea that might be easier for everyone to understand. Create some promissory notes on the side to equalize things. The total going in to the refi is $45k. On an equal basis, that would be $15k each. The person putting $35k in is putting in his $15k. Plus he's loaning $15k to the person putting nothing in and $5k to the person putting in $10k. You could make the interest rate on the notes the same as the mortgage rate so there's no arbitrage going on. Or charge more. It's up to you. Then periodically - no less than once a year - pay the interest on the notes.

The cash flows from the rental would be split 1/3 each just as before. After the cash is distributed to each partner, then the two partners cut their own checks to the third partner to make the payment on the notes. Don't try to short cut that step, as you want the paper trail to agree with the form of the transaction.

You'd probably want to make the notes due in full if the property is sold or there is a cash-out refi in the future.

What is the new agreement (after the refi) on how the monthly/annual profits and losses are to be split?

And what about the notes that were suggested near the end of this thread? You probably need to write down an agreement among the three of you that lays out all of this on a piece of paper, whether you formalize it through a partnership of some sort, or not. This also will support the paper trail that Phil mentioned concerning actually paying (and collecting) the interest on the notes. A major use of contracts is to jog memories and help honest people remember among themselves today what they thought they'd verbally agreed to last year.

Eric Hines

In a title situation, I have never known a lender who would not want all the property owners sign the mortgage. Now, the note is another subject altogether. Any one or all of the owners may sign the note; however, they will be responsible for the payment of the note. The mortgage merely securitizes the note.

This is a great point and something I had glossed over. If the mortgage is refinanced with only 1 or 2 of the 3 owners, then 1 or 2 owners may be on the note, but all 3 will most likely remain on the mortgage. For example I Googled up this quote:

"A note is signed by the people who agree to pay the debt. A mortgage is signed by those who own the property being mortgaged."

So from a tax perspective, do you report the mortgage interest on your taxes if you are on the note, or the mortgage? In my example, 2 owners are on the new note but the third is not. The third person is not obligated to pay the interest, so can they declare that interest as an expense on their taxes? You would think not. But if not, would the interest be split among the other two owners, according to their percentage interest in the mortgage?

ptheland: " . . .

Another approach would be to look at the equity in the property before and after the refi.

Before the refi, everyone has $16.7k of equity. One-third of the $50k total equity. After the refi, the one who put nothing in has $16.7k less $1.7k (for their share of the refi costs), or $15k of equity. The person putting $10k in will have $25k of equity, and the person putting $35k in will have $50k of equity. The math still works, 300 of value less 210 loan is 90 of equity, which is the total of 15 + 25 + 50.

That makes the ownership shares 50/90 (55.6%), 25/90 (27.8%), and 15/90 (16.6%). The person putting in the $35k is buying part of the property from the other two owners.

The immediate result is that the two selling owners would need to recognize any gain on the partial sale of the property. (Losses would probably not be recognized due to related party issues.)"

If you are inclined to follow this example, then each of the two selling owners should be executing a deed for 16.7% (33.3 - 16.6) and 5.5% (33.3 - 27.8), resepctively to the third owner to get him/her to 55.6% (33.3 + 16.7 + 5.5) NOTE - rounding errors.

Doing this would then also change all subsequent annual allocations and gives the one owner a much larger share of future appreciation.

And this is why this board always recommends an ownership agreement to parties who are not married at the time of purchase; I realize that your questions posited an inheritance, but for those not inheriting, these questions should be addressed in advance.

Also, what about if one or two owners want to sell and one or two owner do not. Are you intending to leave partition through the legal ssytem as the only avenue of resolution, or would you consider buy/sell provisions or, alternatively, sale of entire property upon less than 100% agreement?

Regards, JAFO

Subject to same caveat - Not legal advice, consult an attorny, etc.

So from a tax perspective, do you report the mortgage interest on your taxes if you are on the note, or the mortgage?

In your case, I'd say it doesn't matter.

We're talking about investment property here, not a residence. Residences have some specific requirements regarding ownership and liability for the loan. Investment property does not.

With investment property, the things actually happening are as important as the formalities. Although each partner might not be legally liable for the loan, their property is encumbered by the loan and they are making payments on the loan. Therefore, they can deduct their portion of the mortgage interest.

--Peter

If you are inclined to follow this example, then ...

The same could be said about all of the examples. There are many details to tend to when implementing any change in real estate ownership and/or financing. Since the OP still appears to be in the planning stages, I've omitted all of those details.

Doing this would then also change all subsequent annual allocations and gives the one owner a much larger share of future appreciation.

This definitely needs plenty of emphasis. Going this route (selling a partial interest) would permanently give the one partner a larger share of the whole operation. That may or may not be the intention of the parties.

--Peter

Just want to highlight another consideration. Refinancing a $250K mortgage note owed by three co-obligors with a new $210K mortgage note with two co-obligors and $45K of cash releases one person from liability for over $80K of debt. If there's no consideration for this liability release, it's a gift from the two co-obligor siblings to their brother. Gift tax reporting at least would be required (though no tax may be due unless lifetime credit has been utilized, etc.). If a gift of $80K+ is not intended, there ought to be some documentation of the released brother's obligation to make his brothers whole for a third of the mortgage debt when the property is sold. Otherwise, the release can result in cancellation of indebtedness income.

Furthermore, if there's no documentation that the released brother is still liable for his one-third share of the original mortgage, despite his name not appearing on the note, what happens if the property is sold a month later? Assume it sells for its market value of $300K, and after satisfaction of the mortgage note, there's $90K on the table (ignoring closing costs). One brother is legally entitled to $100K, which is one third of the gross proceeds (since he had no liability on the note). The other two --- the ones with more skin in the game --- not only get nothing but have to kick in $10K. Sound fair? Sounds like a lawsuit to me.

If you don't think this will happen because of the relationship between the sibling co-owners, think about what might happen if the released brother were to meet an untimely fate the day after closing the refi. How's the note signers' relationships with their sibling's heirs? And what if his financial situation gets to where he files bankruptcy, and his creditors force a sale of the property? Don't think they'd demand $100K?

Putting a partnership agreement in place would seem to me to simplify rather than complicate things. But that's just another random view.

I further assume that you mean two on the mortgage note and all three on the mortgage. Or are you stating the the new lender will be satisfied with a lien on an undivided 2/3rds interest in the property?


Yeah, that's my question, too. A lender has to be able to foreclose on a property if payments aren't made. They will have to require all three brothers sign...

This whole thing is just a big mess, though, I agree with the final poster who pointed out what happens if one brother passes and his heirs want their money out...

Yeah, that's my question, too. A lender has to be able to foreclose on a property if payments aren't made. They will have to require all three brothers sign...

This whole thing is just a big mess, though, I agree with the final poster who pointed out what happens if one brother passes and his heirs want their money out...

You mean lenders don't just forge all the signatures anymore?