Contributed by: MatthewD, FreeTaxUSA Agent, Tax Pro
George and an investor friend purchased a home to rent out. The goal is to hold onto the home, collect rent, wait for the value to increase, and then sell the home to earn a gain on their investment. Selling the house will raise several tax considerations that George and his friend will need to address when preparing their tax returns.
Owner percentage
When a rental property with multiple owners is sold, each owner is taxed separately based on their ownership percentage. Each co-owner must report and pay capital gains tax on their share of the profit and may also owe tax on income from depreciation recapture.
Is this a partnership?
Does being in this situation mean you must file Form 1065 as a partnership? Not necessarily. Joint owners don’t automatically report rental activity on a partnership return. It depends on your ownership structure and how actively you manage the property.
- Simple Co-Ownership: If you own the property together and just share the rent and costs, you don’t file Form 1065.
- Schedule E: Each owner reports their share of the income and expenses directly on Schedule E of their own personal tax return (Form 1040).
When You Must File Form 1065
- Formal Partnership or LLC: The IRS generally requires a partnership return if your rental property is owned and operated through a multi-member LLC or a formal partnership.
- Business Services: Providing active services like daily cleaning, food, or concierge work turns a passive rental into a business, triggering a Form 1065 filing.
George and his fellow investor use a rental management company and are essentially hands-off when it comes to managing the property. They’re a simple co-ownership and will use Schedule E along with Form 1040.
Co-Owner Tax Responsibilities
When a jointly owned rental property is sold, IRS rules require the owners to divide the sale into individual tax events. Three things must be considered:
Ownership Percentages: Each owner’s taxable profit or deductible loss matches their agreed ownership share. For example, if two owners have a $100,000 profit on a 50/50 property, both owners report a $50,000 gain individually.
Cost Basis & Improvements: An individual owner’s initial cost basis (the purchase price) is their share of the original cost, plus their share of any documented capital improvements made over the years.
Selling Expenses: Selling expenses (such as broker commissions, closing costs, and legal or escrow fees) are divided among the co-owners and used to proportionally reduce each individual's net taxable gain.
George and his friend each have an ownership percentage of 50% in the home.
A sale price of $360,000 means that each person reports $180,000 as their share of the sale price. With a purchase price of $280,000, each person reports $140,000 as their share of the purchase price, plus half of any qualifying purchase costs. The sale will likely involve selling costs as well. For example, $18,000 in selling costs would mean that each person reports $9,000.
If George used FreeTaxUSA in the prior year, his rental information should already be saved in his account in the Rental Income section. He can report the sale of the property in that same section.
Depreciation must also be reported. Each year, depreciation taken lowers the cost basis of each person’s share. If the property is sold at a gain, prior depreciation is “recaptured”. It is treated as capital gain but taxed at ordinary income rates (up to a maximum of 25%). Any gain beyond the depreciation recapture portion is taxed at capital gain rates if the property was held for over 1 year, or at ordinary income rates if it was held for 1 year or less. Purchasing another similar income-producing property may allow you to defer taxable gains through a 1031 exchange for like-kind properties.
Passive Activity Losses
Passive activity losses are reported on Form 8582. Any passive activity losses limited in prior years and carried forward may be claimed in the year of the sale. The losses reported in the year of the sale may offset ordinary income.
Summary
Selling a rental property with multiple owners involves each co-owner reporting their share of capital gains and depreciation recapture taxes based on ownership percentage. This summary explains tax filing requirements and key responsibilities for co-owners upon sale.
- Co-owners with simple co-ownership report income and expenses on Schedule E individually; formal partnerships or active rental businesses must file Form 1065.
- Taxable profit, cost basis, and selling expenses are divided proportionally by ownership share, with depreciation recapture taxed up to 25% and capital gains taxed at long-term or ordinary rates depending on ownership duration.
Suspended passive activity losses can be claimed in the year of sale, offsetting ordinary income.