If you operate as a partnership in the US, like how our funds are formed as an LLC,you are supposed to fill in an Internal Revenue Service tax form called the Schedule K-1 or Form 1065. In this article we are specifically going to be talking about partnership in the form of an investment in private real estate.
These investments provide an excellent tax advantage because all income and expenses from the partnership are passed through to the owners of the property. This includes all investors in a fund since you are considered a part owner of the real estate owned by the fund. For tax purposes, this provides advantages such as tax deferral, tax shields and the availability of promising a capital gains rate paid at sale. The US tax code works helps you avoid double taxation on these investments.
The information included in the K-1 tax form includes the individual investor share of each partner, their losses, credits and deductions. The form also contains contributions made by the investors and any distributions that happened during the year it is being filed for.
This form is similar to the tax reporting Form 1099 where stock interests and dividend information is shared. The partner or the individual investor is supposed to report this information on their own tax returns. To understand it better,let’s consider a business that generates a taxable income of $200,000 with partners that have equal shares. Each partner would receive a K-1 with $100,000 of income on it.
K-1 and other Tax Filing particulars for Private Real Estate Owners
When taxes are being filed, there are a number of items to be considered, especially for investors.Some of the considerations include the value of their investment, the losses incurred as well as deductions to take. We’ve compiled a list for the same and discussed each factor in detail. This is simply for educational purposes and should not be taken as tax advice. We believe no one who invests with us should file their taxes themselves and should always use a certified tax professional preferably with a specialized skill in private real estate tax strategies. We work with some of the best accountants in the country and can always offer a referral if needed. Your tax professional will know exactly what to do with the K-1.
Although aK-1 is extensive, it does not tell you the value of an investment. If an investor wants to view the actual value of their property, they can log in to the account they’ve made on our platform and have a look at the net asset value.The form only reports what the tax charged are based on.
In a partnership, there are two types of criteria when it comes to calculation of taxes. One is an inside basis and the other is an outside basis. Both the basis stem from the initial capital contribution of the partner and as time passes,taxable income and contributions will add to the basis. Similarly, any depreciation,expenses and distribution will reduce the basis. Outside basis is the LLC interest of the investor and can be increased by the share of partnership liabilities. The inside basis is the investor’s basis in the assets.
The outside basis can be impacted by the sale of a partnership interest, withdrawal of partnership etc.
If you have an investment in value-added real estate, there will often be a loss reported on the K-1 form as the income is little to none in the first few years while repositioning. Non-cash deductions such as depreciation will be included and if your asset has a depreciation deduction of $150,000 on an NOI of $50,000, the net loss will be $100,000. If there are two partners with an equal share in the property, each of them will receive a K-1 form with a loss of $50,000.
One thing that should be kept in mind is that taxable income is reduced due to depreciation of an asset. This gives a long-term tax advantage to the partners as compared to other forms of investment such as stocks and bonds. It can sound counter intuitive that an investment with a “loss” can be a good thing, but it can be a great thing for tax purposes and you’re still collecting income on the property!
Tax Deferral Advantages
There are certain tax deferral advantages associated with private real estate. An example of one such distribution is the refinancing of an existing property. If you have a sufficient basis, the distribution will not be subjected to taxes upon receipt.
When the asset is sold, the investor will have to take care of taxes and will find a reduction in tax basis due to distribution.
K-1 Delivery and Deadline of filing
To ensure that you aren’t late in filing your K-1s, it is best to be in touch with fund managers regarding their delivery. A number of investors experience K-1s being delivered in September and often file for extensions. There are of course layers and complications involved in finalizing the terms of partnership tax returns. Therefore it is advisable that an extension is requested by the investors to avoid failure-to-file and the penalties associated with it. When it comes to estimated taxes, it is advisable that they are paid before the April deadline. In case of a delay in receiving K-1s, the fund manager should be able to help you draft one to evaluate the estimated tax liability.
Depending on the investment structure you have in place, there may be several federal and state K-1s that you will receive. To avoid this confusion, we have a fund structure so that management of all the K-1s are taken care of. Investors ideally shouldn’t have to manage K-1s for every single property they have stakes in.
A composite return is an individual return filed by flow-through legal entities that are supposed to report state-income. If an investor is participating in composite return filing, their state tax filing requirement will be full filled. This will also eliminate the need to file multiple tax returns. Of course, this scheme is now for all investors and many will not find it favorable since state taxable income is usually subject to the highest tax rate depending on what state you are in. Another drawback to composite returns is that itemized deductions cannot be claimed against the income.
The primary advantage of composite returns is that it can compensate the investors’ share of tax liability in terms of their state-level income.
The form is an integral part of the tax return process. Therefore a thorough understanding of all terms and conditions that entail a partnership are important as they will assist you on how to file a K-1 Form.