Understanding Tax Treatment: Property Rented to a Nonpassive Activity with Partners

Thanks for the explanation. Quick follow-up question - if they're treating their portion as passive income and we're treating our portion as nonpassive, do we need to do anything special on the partnership tax return for the real estate LLC? Like, do we need to specifically allocate the income differently or just handle it on our individual returns? Also, does this affect our ability to deduct passive losses from other investments against this income? I'm guessing it does since our portion would be nonpassive...

For the partnership tax return (Form 1065) for the real estate LLC, you don't need to do anything special. The partnership reports the total rental income in the normal way. The characterization as passive or nonpassive happens at the individual partner level on each person's Schedule E. You're correct about the passive loss limitations. Since your portion of the rental income will be characterized as nonpassive, you cannot use passive losses from other activities to offset this income. Your silent partner, however, can use passive losses from other activities to offset their portion of the rental income (subject to the normal passive activity loss limitations). That's one disadvantage of the self-rental rule - it prevents you from using passive losses against what would otherwise be passive income.

Did taxr.ai help with figuring out how to report this on your actual tax forms? I'm in a somewhat similar situation with a family business that rents from another family property LLC, and I'm really confused about how to properly document all this on my tax forms.

How does this taxr.ai thing actually work? Is it just another AI chatbot but focused on taxes? I'm skeptical that it would understand complicated partnership rules better than a real accountant who's been doing this for years.

Yes, it did help with the tax forms! It explained that I needed to report the income normally on Schedule E from the K-1, but then I had to identify the nonpassive portion and report it separately. It gave me line-by-line guidance for my specific situation. It's not just a chatbot - it's specifically designed to analyze tax documents and provide personalized guidance. You upload your documents and it extracts the relevant information to give you specific advice for your situation. I was skeptical too, but it caught nuances about the self-rental rules that I hadn't considered.

How exactly does this work? Do they somehow get you to the front of the IRS phone queue? That seems impossible given how notoriously difficult it is to reach the IRS.

I'm pretty skeptical this actually works. The IRS phone system is completely broken - I've literally tried calling 20+ times this year and never got through. If this actually works, it sounds like they're doing something sketchy to game the system. Also, I wouldn't trust random IRS phone agents for complex partnership tax questions anyway.

It uses an automated system that navigates the IRS phone tree and waits on hold for you. When an agent finally answers, you get a call connecting you directly to them. It's completely legitimate - they're just using technology to handle the waiting part. I was skeptical of getting tax advice over the phone too, but I had specific questions about how to properly document the passive/nonpassive split on my forms, and the agent was able to pull up the exact regulations and guide me through it. For complex interpretations you might still want a CPA, but for procedural questions about how to properly report something, the IRS agents can be very helpful.

Thanks for bringing that up! Our lease agreement was actually drawn up by our attorney to reflect fair market rent for similar properties in our area. We're not trying to shift income - we're paying what we'd pay anywhere else. Does the operating agreement need specific language about the tax treatment being different for different partners? Or is that just handled on our individual returns? Our current agreement just specifies the ownership percentages.

You're already ahead of the game by having documented fair market rent - that's excellent. The operating agreement doesn't need to specifically address the different tax treatment since that's determined by tax law rather than your agreement. However, if there are any special allocations of profits/losses that differ from the ownership percentages, those definitely need to be spelled out in the agreement with substantial economic effect language. For example, if your silent partner gets a preferred return or if there are special allocations for tax depreciation, those need to be documented. But the passive/nonpassive characterization happens at the individual level on your personal returns, not at the partnership level.

How much documentation is enough? I work in my business every day but I don't keep a formal timesheet or anything. Would bank records, emails, and calendar invites be sufficient? Or do I need to start tracking hours specifically?