This article is part of our passive investors guide on real estate syndications, available here.
Investing into private real estate offerings such as a multifamily real estate syndication enables passive investors, who in a partnership are referred to as Limited Partners (LP), access to tremendous passive income tax benefits. These tax benefits are passed down to the passive investor in the form of a document issued by the Internal Revenue Service (IRS), and that form is called the Schedule K-1 (Form 1065).
In this guide, we’ll go in-depth about what a Schedule K-1 is, how you read a K-1, how net rental real estate income or passive income is taxed, and much more.
What is a Schedule K-1 Form & How Does it Affect Your taxable income?
The U.S. tax code allows for entities such as Partnerships, S corporations, Trusts, and Estates to issue a K-1 to the owners or partners in an investment. The partnership itself does not pay taxes; each individual in the partnership is responsible for their share. The direct ownership that passive investors get from investing in a syndication, for example, is all the pass-through tax advantages and all the investment income and expenses that flow down from the partnership to each owner in the deal.
The General Partner (GP), also referred to as the syndicator or sponsor of a deal (like us here at Willowdale Equity), would prepare and file a 1065 information tax form. The partnership would then calculate a K-1 tax form that details each limited partner/passive investor’s share of the firm’s income, losses, deductions, credits, and how many distributions were given to them in that year. The passive investor or LP would then file their K-1 with their personal tax return.
For simple math, let’s say we have $1,000,000 in income in the given tax year and only two partners. Each partner would receive a K-1 reflecting their income pro-rata share of the partnership, which in this case would be $500,000 each.
Schedule K-1 Form Sections You Should Know
There are four main boxes that every passive investor must understand when reading their K-1 form.
To get a blank example Schedule K-1 form, you can visit the IRS’s website.
- 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 shows a breakdown of the LP’s ownership percentage in the deal. A simple example would be if the partnership raised $1,000,000 and this LP invested or contributed $50,000 into the partnership, reflecting a 5% ownership percentage.
Box 2 - Net rental real estate income (loss)
Box 2 reflects the net rental income gain or loss or simply how much money was made or lost for the LP based on their share of ownership. This net number calculates revenues and fewer expenses and includes all the depreciation that can be utilized.
Sometimes, the depreciation can exceed the net income number, reflecting a “Net rental real estate income (loss)” like in the above example where this LP has a -$12,000 loss, even though they received $3,000 in distributions on the year.
Box 19 - Distributions
Box 19 shows the total amount of distributions we’re paid to the investor in the said year. In the above example, the LP received $3,000 in distributions throughout the year, even though box 2, “Net rental real estate income (loss),” shows a loss of -$12,000.
The loss does not reflect underperformance from the investment or loss of capital; it’s just a “paper loss” that the investor gets from the depreciation, and the net number reflects their share of the “paper loss.” The “paper loss” allows us to keep more from our investments, lowering our passive income taxable amount to as low as $0 in some cases.
Box L - Partner's capital account analysis
Box L shows a snippet of the LP’s capital account. The capital account reflects how much they invested into the deal from the start of the investment, how much they contributed during the year, and what they earned during the year from the partnership.
In the above example, under “Beginning capital account,” you can see that this LP invested $50,000 to start the investment. Also, under “Withdrawal & distributions'” you can see that they received $3,000 in distributions during the year. It also shows the “paper loss” of $12,000 under “Current year net income (loss),” which reflects what they made or lost on the year, “on paper.”
When should I receive my K-1?
Filing a partnership return is a significant task that requires many experts to help ensure the accuracy of the information and that the partnership maximizes all of the deductions it can take advantage of.
This is crucial because each individual investor will receive their K-1 based on the partnership’s fillings, so accuracy is critical. That said, it takes some time to put everything together and adequately file the partnership return.
Individual investors or LPs should expect to receive their K-1 sometime between mid-March to early April. But in some cases, the filing can be very complicated and may require a filing extension which would delay when LPs would receive their K-1. Please keep in contact with whomever the GP or sponsor is for the deal you’re invested in to get a good idea of the expected timelines for your K-1.
Is rental income passive income?
The general rule from the IRS is that all rental real estate activity is passive, meaning that passive losses from rentals can only be offset by other passive income or gain.
K-1 net rental real estate income
The tax benefits of passive investing in multifamily syndication are key advantages, especially when you compare it to investing in a Real Estate Investment Trust (REIT). These excellent passive income tax benefits allow investors to create paper losses through what the IRS calls depreciation. The IRS allows us to write off the normal wear and tear usage of the building but not the land over 27.5 years.
Items like plumbing fixtures, windows, and equipment, to name a few, are considered personal property, and the goal is to find the total value of these items and depreciate it over the same 27.5-year period. There’s another way to accelerate that depreciation and claim more “paper loses” is through a cost segregation study.
This would require hiring a private engineer to come out and do a cost segregation study on the property to establish the value of the personal property.
For example, let’s say the building produced $100,000 in cash flow, but we can claim -$150,000 of depreciation against our cash flow. That would mean we have a -$50,000 loss for the partnership, but let’s say there were only two partners.
Each partner would get a K-1 reflecting a -$25,000 net rental loss even though they made $50,000 in cash flow each.
How is K-1 income taxed and the passive income tax rate
In contrast to your earned income, the Schedule K-1 that you receive each year reflects your net rental real estate revenue – which is the portion subject to lower taxes after subtracting all depreciation. The income you receive from working your W-2 or business is referred to as earned income and is subject to the highest effective tax rate.
You’ll submit the K-1 with your personal income tax return once you receive it. If your K-1 is positive, you’ll have to pay the marginal tax rate on that revenue; if your K-1 shows a loss, you won’t have to pay any taxes! You will have to pay federal and state income taxes depending on where you reside in the United States.
How is K-1 income taxed for real estate investors: Example 1
In the above example, let’s say we received a K-1 showing an income of $10,000, and let’s say where I live, and based on my tax bracket, I would fall into the 37% tax rate. Then 37% of the $10,000 (-$3,700) would go to uncle sam on my personal income tax, and I would keep $6,300 of that $10,000.
How is K-1 income taxed for real estate investors: Example 2
In the above example, let’s say we received a K-1 showing a loss of -$12,000; in this scenario, I would not owe anything on my personal income tax, even though I may have received a couple of thousand dollars in distributions that year.
Business income, ordinary income for the tax professional. What you need to do with a Schedule K-1
When getting K-1 forms or discussing ordinary business income, leveraging a professional accountant or a reputable website is best. You may still be required to pay tax on any earnings received in retirement accounts on shares held inside a retirement plan for what is called “unrelated business taxable income,” or UBT.
The UBTI occurs when a person has received any income considered ordinary: wages, salary, and tips; rental income from real estate investments; business income from a partnership or an S-corporation.
For years, certain retirement accounts would not be taxed on these accounts. The earnings not put into retirement plans are considered UBTI, which is directly listed on a Schedule K-1. You are required to report this taxable amount at line 43 of your 1040 tax return and will need to complete Form 990-T. You will be issued a deficiency notice if you do not pay the income and distribution tax.
How does K-1 loss affect my taxes?
Since rental real estate activity is passive, you can only offset your passive income with your passive losses, which means you cant apply your passive loss toward your Active or Earned income to reduce your tax liability. However, this can be done if you qualify for real estate professional status, allowing you to carry over your losses.
Typically it would be harder to qualify if you’re not a full-time real estate investor and if you had a full-time job outside of real estate. But there are cases where couples qualify for Real Estate professional status together.
For Example, There was a case of a doctor making $3M a year in active W2 income who had purchased enough commercial real estate and accelerated the depreciation on these assets. He generated enough depreciation or paper loss on this that he was able to offset his entire $3M income on the year.
The IRS had audited him and lost, as his wife, a stay-at-home mom, qualified as a real estate professional as she managed the properties.
Frequently Asked Questions About How Is K1 Income Taxed
If your K-1 shows a profit, you’ll be paying the marginal income tax rate on that profit; if your K-1 shows a deficit, you won’t owe any taxes.
Yes, K-1 distributions are considered income, but it’s important to note that the net gain/income on your K-1 is a net number after subtracting your share of the partnership’s income, losses, deductions, and credits.
Rental real estate is passive; you can only offset your passive income by canceling out your passive losses. However, if you meet the requirements for real estate professional status, you may carry over your passive losses towers your active/earned income.
How Is K1 Income Taxed Conclusion
Understanding how a Schedule K-1 functions and how to read it is crucial to the function of being a passive or limited partner in a syndication. This report is your share of the partnership’s income, losses, deductions, and credits.
Keep this guide close and refer to it every year at tax time. It all starts with understanding your investment options, maybe investing through a self-directed IRA instead of funding your investment as an individual. The higher your overall portfolio income grows, the more you need to know how to decode your schedule k-1 form. Also, the right real estate market is crucial to your success because even if you overpay or come short on a few projections, the market should provide an element of cushion.
DISCLAIMER: This is for informational purposes only. I am not a tax advisor, nor can I provide tax advice; please consult your CPA.
- IRS.GOV, “Partner’s Instructions for Schedule K-1 (Form 1065) (2021)“
- IRS.GOV, “Schedule K-1 (form 1065)“
- Bench.CO, “Schedule K-1 Tax Form: What It Is and When To Complete It“
- TheRealEstateCPA, “What is a Schedule K-1 Form“
Interested In Learning More About PASSIVE Real Estate Investing In Multifamily Properties?
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