What is a K-1 and How is it Used for Taxes in Private Real Estate?
The Schedule K-1 (Form 1065) is an Internal Revenue Service (IRS) tax form issued annually for businesses that operate as a partnership, such as an investment in private real estate with Origin. The U.S. tax code allows the use of certain pass-through taxation for such investments, which means that 100% of income and expenses flow through the partnership to the owners or partners. This is good for tax purposes because the tax deferral, tax shields, and the favorable capital gains rate paid at sale are big advantages of investing in private real estate.
The K-1 tax form reports each individual investor’s share of the partnership’s earnings, losses, deductions and credits from the business and any contributions or distributions made during the year. It serves a similar purpose for tax reporting to the Form 1099, which reports interest and dividends from stock investments. The individual investor then reports this information on his or her tax returns. For example, if a business earns a taxable income of $100,000 with two equal partners who share in the income pro-rata, each partner can expect to receive a K-1 with $50,000 of income on it.
Important K-1 and Tax Filing Information for Private Real Estate Investors
Private real estate investors should keep the following in mind when filing their taxes:
Valuation: As elaborate as a K-1 is, it does not report the fair value of the investment and it simply reports the tax basis of the investment. Origin investors can view the actual value of their investment by logging in to their Origin account and looking at the net asset value.
Tax Basis: There are two types of basis associated with a partnership – inside basis and outside basis. Inside basis is the partnership’s basis in the assets. Outside basis is the partner’s basis in the LLC interest and can be different from the inside basis.
A partner’s inside and outside basis begins with the original capital contribution. Over time, taxable income and additional contributions will increase the basis while depreciation, expenses, and distributions will reduce it. The outside basis is further increased by the partner’s share of partnership liabilities and reduced by repayments of liabilities.
It is important for partners to keep track of the outside basis to understand the impact of certain events like the sale of a partnership interest, how much a partner may withdraw from a partnership without recognizing additional gain and the extent to which losses can be deducted.
Let’s consider a simple example where an investor contributes $1,000,000 for a 50% interest in a partnership. The business generates $400,000 in annual revenue, $200,000 in operating expenses and is allocated $100,000 in depreciation. The taxable income for the year is $100,000 ($400,000-$200,000-$100,000). The investor’s share of income is $50,000, and there is a distribution payment of $100,000.
The partner’s ending basis in the partnership will equal $950,000 as outlined below:
|Ending Tax Basis||$950,000|
If the investor subsequently sells the partnership interest for $1,000,000, he/she should expect to recognize a gain equal to the excess of the proceeds over the outside tax basis. The outside tax basis cannot be reduced below zero.
Losses: A K-1 may show a loss due to current year non-cash deductions such as depreciation. It’s common in value-added real estate for losses to be incurred on the K-1 because these assets produce little to no income, but receive the tax-deferral benefit from depreciation. For example, if an asset generates $50,000 in net operating income and has a depreciation deduction of $150,000, the business would report a net loss of $100,000 for tax purposes. If there are two equal partners, each partner would receive a K-1 with a loss of $50,000.
|Net Operating Income||$50,000|
|Loss Per Partner||($50,000)|
As displayed above, depreciation reduces taxable income that would otherwise be allocated to partners. This provides a long-term tax advantage to income from real-estate as compared to other sources of income like dividends and interest from stocks and bonds that are typically taxed to the extent of cash received by the investor.
Tax Deferred Distributions: Certain distributions provide tax deferral advantages, such as distributions made as a result of refinancing an existing property. Assuming the partner has sufficient basis, these distributions are not taxable upon receipt. However, the tax basis will be reduced by the amount of the distribution and the investor will get caught up on taxes when the asset is sold.
K-1 Arrivals: Real estate investors should contact their fund manager for details relating to the delivery of their K-1s. At Origin, we have been sending investors their K-1s around the first week of April. That said, generally, partnerships file an extension and it is not uncommon for investors to see their K-1s being delivered as late as in September. This is due to varying levels of complexities involved in finalizing the partnership tax returns. Therefore, it is advisable for investors to obtain an extension to avoid a failure-to-file penalty. That said, estimated taxes must still be paid prior to the April filing deadline. So, if you don’t receive your K-1s on time, you might want to contact your fund manager for draft K-1s to determine your estimated tax liability.
Multiple Forms: Investors may receive several federal and state K-1s depending on the type of investment structure. At Origin, we typically have a fund-structure so that our investors don’t have to manage multiple K-1s for every property in which they have a beneficial interest. For example, if Investor A invests in a fund comprised of 20 properties and Investor B invests in 20 different individual properties structured as partnerships, both will have to file multiple state K-1s. But Investor A will only receive one federal K-1 and Investor B will have to file 20 federal K-1s.
Composite Returns: While not all states allow this option when a Fund files a composite return, it is able to pay the investor’s share of tax liability attributable to the state-level income. An investor’s state tax filing obligation may be satisfied by participating in the composite filing option that may alleviate the burden of filing multiple state tax returns. Not all investors will be eligible or find this beneficial as the state taxable income will generally be subject to the highest tax rate that the states allow. Investors also cannot claim itemized deductions against this income on a composite return.