Passive investors, who in a partnership are referred to as Limited Partners (LP), have access to tremendous tax benefits when they invest in private real estate offerings such as an apartment syndication. These tax advantages are transferred to the passive investor in the form of a document that is provided by the Internal Revenue Service (IRS). The name of this form is the Schedule K-1 (Form 1065).
In this article, we will explain in great detail what a Schedule K-1 is, how it should be read, how the taxation of net rental real estate income or passive income works, as well as a great deal of other information.
But Before That, an Important Disclaimer
I would like to make it clear that I am not a tax professional, nor do I intend to pursue such a career in the future (those people have really tough jobs). As a result, the only source for the ideas and viewpoints presented in this post is my own personal experience. You need to have a conversation with your certified public accountant (CPA) to obtain additional data and specifics on your circumstance.
Important Points To Keep In Mind
A K-1 can be issued by certain types of legal entities in the United States, such as partnerships, S corporations, trusts, and estates, to the individuals who own or are partners in an investment.
Being able to serve as a passive or limited partner in a syndication requires having a solid understanding of the functions a Schedule K-1 does as well as how to interpret the form. This report contains the proportion of the partnership's income, losses, deductions, and credits that corresponds to your investment in the business.
The partnership entity itself is not responsible for making tax payments; rather, the onus falls on each individual partner to pay their fair amount.
When reviewing their own K-1 form, passive investors need to have a solid understanding of the four primary boxes that are included.
Individual investors and limited partnerships can anticipate receiving their K-1 statements between the middle of March and the beginning of April.
What Exactly Is A Schedule K-1 Form, and How Does It Affect The Amount Of Tax that You Have To Pay?
A K-1 can be issued by certain types of legal entities in the United States, such as partnerships, S corporations, trusts, and estates, to the individuals who own or are partners in an investment. The partnership entity itself is not responsible for making tax payments; rather, the onus falls on each individual partner to pay their fair amount. When an investor participates in a syndication, for instance, they receive all of the pass-through tax advantages as well as all of the investment income and expenses that fall down from the partnership to each owner in the agreement. This constitutes direct ownership of the investment for the investor.
A 1065 information tax form would need to be prepared and filed by the General Partner (GP), who is also known as the syndicator or sponsor of a venture (such as Thousand Doors Group). The partnership would then compute a K-1 tax form that would describe each limited partner's or passive investor's share of the company's income, losses, deductions, and credits, as well as the number of distributions that were made to them in that particular year. After that, the LP or passive investor would attach their K-1 to their individual income tax return.
To make the calculation more straightforward, let's assume that we have only two partners and our income for the current tax year is $1,000,000. In this scenario, each partner would be given a K-1 form that reflected the revenue that was proportionately theirs from the partnership, which in this instance would be $500,000.
The Sections of the Schedule K-1 Form That You Need to Know
When reviewing their own K-1 form, passive investors need to have a solid understanding of the four primary boxes that are included.
In order to serve as a template: Form K-1 of the Schedule,
Box J – Partner’s share of profit, loss, and capital
Box 2 – Net rental real estate income (loss)
Box 19 – Distributions
Box L – Partner’s capital account analysis
Box J - Partners share of profit, loss, and capital
Box J provides a detailed breakdown of the LP's ownership stake in the transaction. Consider the following scenario: a partnership has successfully raised $1,000,000, and a limited partner (LP) invests or contributes $50,000 to the partnership. This gives the LP a 5% ownership portion in the partnership.
Box 2 - Net rental real estate income (loss)
Box 2 shows the gain or loss in net rental revenue, or more simply, how much money was made or lost by the LP depending on their percentage of ownership in the property. This "net" amount is arrived at by subtracting total expenses from total revenues and factoring in any and all potential uses of depreciation.
Sometimes the depreciation will be higher than the net income number, which will reflect a "Net rental real estate income (loss)" such as in the example that was given earlier, where this LP has a loss of -12,000 dollars, despite the fact that they received 3,000 dollars in distributions throughout the year.
Box 19 - Distributions
Box 19 displays the aggregate amount of payments that were paid out to the investor during the specified year. Even though there was a loss of $12,000 reported in box 2, "Net rental real estate revenue (loss)," the limited partnership (LP) in the preceding example was paid out a total of $3,000. in distributions throughout the course of the year.
The loss is merely a "paper loss" that the investor gets from the depreciation, and the net amount indicates their part of the "paper loss." The loss does not reflect underperformance from the investment or loss of capital. Because of the "paper loss," we are able to keep more of what we earn from our assets, which brings the taxable portion of our passive income down to as low as zero dollars in some instances.
Box L - Partner's capital account analysis
Box L displays some information from the limited partnership's (LP) capital account. The capital account details how much money they initially contributed to the transaction, how much money they contributed throughout the year, and how much money they earned over the year from the partnership. It also details how much money they earned during the year.
You can see that this LP initially contributed $50,000 to the investment by referring to the "Beginning capital account" in the example that was just presented. In addition, you can see that they obtained payouts totaling $3,000 throughout the course of the year by looking at the section labeled "Withdrawal & distributions." It also displays a "paper loss" of $12,000 under the heading "Current year net income (loss)," which depicts how much money they gained or lost over the course of the year "on paper."
When Should I Expect To Get My K-1?
Filing a return for a partnership is a substantial process that involves the assistance of a large number of tax professionals to ensure that the information is accurate and that the partnership makes the most of all of the deductions it is eligible to receive.
Accuracy is essential in this situation since each individual investor will receive their K-1 based on the partnership's fillings, and so, it is essential that this information be accurate. Having said that, the process of gathering all of the necessary information and filing the partnership return correctly takes some time.
The K-1 forms for individual investors and limited partnerships (LPs) should be sent out between the middle of March and the beginning of April. However, the filing process can be very difficult in certain circumstances, and it may be necessary to request an extension of the filing deadline; this would result in a delay in the LPs receiving their K-1 forms. Please ensure that you maintain regular communication with the general partner (GP) or sponsor of the transaction in which you have invested in order to obtain an accurate estimate of the expected timelines for your K-1.
Is Rental Income Passive Income?
According to the IRS's general rule, all activities related to rental real estate are considered to be passive. This means that passive losses incurred from rentals can only be compensated by other forms of passive income or gain.
K-1 Net Rental Real Estate Revenue
When compared to investing in a real estate investment trust, passive investing in multifamily syndication offers a number of important advantages, the most significant of which is favorable tax treatment. Investors are able to generate paper losses through a process known as depreciation, which is made possible by these tremendous tax incentives for passive income. Over the course of 27.5 years, the IRS enables us to deduct the costs associated with the building's typical usage, but we cannot deduct the costs associated with the land.
Personal property includes things like plumbing fixtures, windows, and equipment, to mention a few examples; the objective is to determine the overall value of these things and depreciate it over the same 27.5-year period as the rest of the building. A cost segregation study is another method that can be utilized to speed up the depreciation process and claim additional "paper losses." In order to determine the worth of the personal property, a cost segregation study would need to be carried out on the property, which would necessitate the employment of a private engineer to carry it out.
Take the following scenario as an example: the building generated $100,000 in cash flow, but we are able to deduct $150,000 in depreciation from our cash flow. That would imply that the partnership has suffered a loss of $50,000, but let's pretend that there were only two partners involved.
Despite having each made $50,000 in cash flow, a K-1 would be issued to each partner representing a net loss of $25,000 related to the rental property.
How Is The Income Taxed On The K-1, And What Is the Rate For Passive Income?
Your net revenue from rental real estate, which is the portion that is subject to lower taxes after depreciation is subtracted from the total revenue, is reflected on the Schedule K-1 that you receive each year in contrast to your earned income. This portion of your revenue is subject to lower taxes. Earned income refers to money that a person receives as a result of their own efforts, whether in the form of a W-2 or their own business, and is subject to the highest effective tax rate.
Once you have it in your possession, the K-1 must be included with your individual income tax return. If your K-1 indicates a loss, you won't have to pay any taxes; however, if your K-1 shows a profit, you will be required to pay the highest marginal tax rate applicable to that revenue. Depending on the state and federal jurisdiction you call home in the United States, you may be subject to both federal and state income taxes.
How Should Real Estate Investors File Their K-1 Income Tax Returns?
Example 1
In the previous illustration, let's pretend that we were given a K-1 form that showed an income of $10,000. Furthermore, let's imagine that, because of the location in which I live and the tax bracket into which I fit, I would be subject to a tax rate of 37%. The remaining 37% of the $10,000, or $3,700, would be subject to my individual income tax, and I would be responsible for paying $6,300 of the $10,000 total.
Example 2
In the previous illustration, let's imagine that we received a K-1 that showed a loss of $12,000; if this were the case, then I would have absolutely nothing to pay in terms of personal income tax, even though it's possible that I earned a few thousand dollars in distributions during that tax year.
Earnings From A Business, Also Known As "Ordinary Income," For The Tax Preparer. What Is required Of You When Working With a Schedule K-1
Utilizing the services of a qualified accountant or a reliable website is your best bet when it comes to obtaining K-1 forms or discussing regular business income. You may still be obliged to pay tax on any gains earned in retirement accounts on shares kept inside of a retirement plan for what is known as "unrelated business taxable income," or UBT. This type of income is referred to as "passive income."
When a person receives any type of income that is generally regarded as ordinary, such as wages, salaries, and tips; rental income from real estate investments; or business revenue from a partnership or an S-corporation, they are considered to have incurred UBTI.
For a number of years, contributions made to some retirement funds were exempt from taxation. The amount of earnings that are not contributed to retirement plans is referred to as UBTI, and it is immediately recorded on a Schedule K-1. In order to comply with the law, you must disclose this taxable amount on line 43 of your 1040 tax return and fill out Form 990-T. If you fail to make the required payment for the income and distribution tax, a notice of deficiency will be sent to you.
What Impact Does My K-1 Loss Have On My Taxes?
Because renting out real estate is considered a passive activity, the only way to offset your passive income is by using your passive losses. This means that you cannot use your passive loss to offset your active or earned income in order to minimize your tax liability. However, this is something that can be done if you meet the requirements to be considered a real estate professional, which will allow you to carry over any losses.
If you are not a full-time real estate investor and if you have full-time work outside of the real estate industry, it will be more difficult for you to qualify for the program. However, there are situations in which a married pair can achieve the position of real estate professional together.
For instance, there was a case of a doctor who was making $3 million a year in active W2 income. This individual had purchased sufficient amounts of commercial real estate and accelerated the depreciation on the assets he owned as a result of his purchases. Because of the amount of depreciation or paper loss that he produced from this, he was able to cancel out his whole annual income of three million dollars.
The Internal Revenue Service had audited him, but they were unsuccessful because his wife, who was a homemaker and managed the properties, qualified as a real estate professional.
The Following Is A List of Frequently Asked Questions Regarding The Taxation of K1 Income.
Are taxes withheld from your K1 income?
If your K-1 indicates a profit, you will be responsible for paying income tax at the marginal rate on that profit; but, if your K-1 shows a loss, you will not be responsible for paying any taxes.
Are distributions made on K-1 forms considered income?
It is important to note that the net gain or income on your K-1 is a net number after deducting your share of the partnership's income, losses, deductions, and credits. While it is true that K-1 distributions are considered income, it is important to keep in mind that the net gain or income on your K-1 is a net number.
Are K1 losses capable of offsetting W2 earnings?
The income from rental real estate is considered passive, and the only way to counter the passive income is to offset the passive losses. If, on the other hand, you satisfy the criteria for achieving the position of real estate professional, you have the ability to transfer losses from passive activities to your active or earned income.
Conclusion
Being able to serve as a passive or limited partner in a syndication requires having a solid understanding of the functions a Schedule K-1 does as well as how to interpret the form. This report contains the proportion of the partnership's income, losses, deductions, and credits that corresponds to your investment in the business.
Understanding your investment alternatives is the first step in the process. If you don't want to fund your investment on your own, one option is to invest through a self-directed individual retirement account (IRA). The more your overall portfolio income increases, the more it is important for you to be able to understand the information on your schedule k-1 form.
WE'RE HONORED TO BE IN BUSINESS WITH YOU
Building wealth doesn’t always require you to do all the work you normally would as an independent real estate owner/investor. You can also accomplish the same goal by taking advantage of a syndicated real estate project.
Comments