JF2116: 3 Factors On A Schedule K-1 Tax Report | Syndication School with Theo Hicks
In today’s episode, Theo Hicks will be talking about the schedule K-1 tax report. It is a statement that is given to each of the limited partners also known as passive investors. He will be sharing how your passive investor can interpret the K-1. Free document with this episode.
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hi, Best Ever listeners. Welcome to another episode of The Syndication School series – a free resource focused on the how-tos apartment syndication. As always, I’m your host, Theo Hicks. Each week, we air two podcast episodes that focus on a specific aspect of the apartment syndication investment strategy, and for the majority of these episodes, including today’s episode, we offer some free resource. These are PowerPoint presentations, PDF how-to guides, Excel calculator templates, some document or resource that will help you along your apartment syndication journey, or in this case, for today, accompany the episode. All of these free documents as well as past syndication school series episodes can be found at syndicationschool.com.
Today we’re going to talk about taxes, and then more specifically, we’re going to talk about the Schedule K-1 tax report for apartment syndications. The Schedule K-1 tax report is the tax report that is given to each of the limited partners, the passive investors in your apartment syndication deals. So in this episode, we’re going to talk about how your passive investor can interpret that Schedule K-1 and what the different boxes or at least the important boxes mean.
Now before we get into any of that, it’s important to say that this is for informational purposes only. I am not in a tax advisory firm, I am not an accountant, I’m not a CPA. So any general tax-related real estate questions that you have or that your passive investors have, you should tell them to talk to their own accountant. But what we can say is that passive investors like to invest in real estate opportunities because of the tax advantages that may potentially come from write-offs and losses due to depreciation, but we don’t include any of those assumptions about any of these tax advantages in the projections. So this is a disclaimer that we have to say when we’re talking about these types of things, because I’m not an accountant. This is just general information education on what those little boxes mean on a K-1. So now that it’s out of the way, let’s get into the actual meat of the discussion today.
So as I mentioned in that disclaimer, apartments syndications are very attractive to passive investors because of the different tax benefits, and we’ve talked about the major tax benefits or at least the tax factors involved with apartment syndication – depreciation, accelerated depreciation, capital gains versus income tax, cost segregation studies, things like that. So if you google ‘Joe Fairless tax factors’, a blog post or a syndication school episode will come up…
But the foremost benefit is the depreciation. So whenever you have a fixed asset, such as an apartment community, its value reduces over time due to the usage and normal wear and tear. So depreciation is the amount that can be deducted from the income each year to reflect this reduction value from usage and normal wear and tear, and the IRS classifies each of these depreciable items according to the number of years of its useful life. So over this period of time that apartment can be fully depreciated, whatever that useful life happens to be, which we’ll go into in a second.
Now there’s also, as I mentioned, the cost segregation study, which actually goes in there and identifies building assets that can be depreciated at an accelerated rate, using a shorter depreciation life. These are things that you actually have to go there physically in person to see, and they’re not on any document or report. So these are interior and exterior components of the building, the structure, it may be part of a newly constructed building or existing building that has been purchased or renovated. So about 20% to 40% of these components of an apartment, these interior, exterior, structural components can be depreciated at a faster rate than the building structure itself. So a cost segregation study dissects the purchase construction price of a property that would normally depreciate over 27 and a half years, and figure out what things can be depreciated over five, seven and 15 years. So as opposed to the entire value depreciating slowly over 27 and a half years, 20% to 40% of those things depreciate over five, seven and 15 years, again, which drastically increases the amount that can be written off, and the remaining is depreciated over at 27 and a half years.
So if the expense of the construction purchase or renovation was in a previous year, favorable IRS rulings allow taxpayers to complete a cost segregation study on a past acquisition or improvement, and take the current year’s deduction for resulting accelerated depreciation not claimed in prior years. So if you’ve owned a property for five years and haven’t done the accelerated depreciation yet, and you do a cost segregation study, those components that depreciate over five years can be fully written off that next year. That’s what they’re saying. This is just a brief explanation of how the cost segregation and calculating the depreciation works. If you want more specifics and some examples, you can go and check out that Five Tax Factors When Passively Investing in Apartment Syndications blog post, where there’s a lot more actual numbers and formulas and calculations for how to do an example depreciation write-off.
Now, as I mentioned, each year, the general partners’ accountant will create a Schedule K-1 for all the limited partners for each apartment syndication deal, and these passive investors will then file that K-1 with their tax returns to report their share of the investments, profits, losses, deductions and credits to the IRS, which includes any depreciation expense that is passed on to them, assuming it is passed on. So we’ve got a sample K-1 that you can download for free and see what it looks like. It’ll be in the show notes of this episode, so make sure you check that out; check that out at some point. It’d be nice if you had it open right now while we’re having this conversation, but it’s not completely necessary, because there’s only three boxes that are the most relevant to your passive investors. It’s box number two, which has the net rental real estate income loss. It’s box 19, which has distributions, and then Section L partners’ capital account analysis.
So if you check out the sample K-1, box number two says net rental real estate income, and then [unintelligible [00:10:19].11], the number is -$50,507. So what does this mean? This is the net of revenues less expenses, including the depreciation expense pass through to the LPs. So for most operating properties, the resulting loss is primarily due to accelerated depreciation. As I mentioned, on the sample K-1, the depreciation deduction that passed through to the limited partners is $50,507, thereby resulting in an overall loss. So negative taxable income. So that’s the amount that was written off through that accelerated depreciation. That’s one important piece of the K-1.
The second is box 19 distributions. So going back to our sample K-1, box 19 says $1,400. So what is this? This is the amount of equity that was returned to the limited partner. So on the sample K-1, the limited partner received $1,400 in cash distributions from their preferred return of distributions, as well as profits. So just because the LP realized a loss on paper does not mean that the property isn’t performing well. This loss is generally from accelerated depreciation, not from loss of income or capital. So here they made $1,400, and then they lost $50,507. So does that mean that the property is doing really bad and that it has lost money? Well, no. It’s just the depreciation. So it’s the loss of value of the overall property from depreciation from normal wear and tear, not some loss of income or loss of capital or loss of equity.
So the third is Section L partners’ capital account analysis. So going back to our example, K-1, it says partners capital account analysis, and then beginning account balance is blank, capital contributed during that year is $100,000, current year increase or decrease isn’t -$50,507, withdrawals and distributions is $1,400, and the ending capital account is $48,093. So what does this mean? Well, so I invested $100,000 that year, $50,507 is from depreciation, so you subtract that, and you also subtract the $1,400 in cash division, and you’re left with $48,093. So does this mean that the capital balance is lower and that the preferred return is now going to be lower, and it’s not only based off of that $48,000 figure? Well, no. This figure is for tax purposes only; it is the tax basis, it is not a capital account balance. So the limited partner would not receive a lower preferred return distribution based on this tax basis of $48,000. From at least Ashcroft’s perspective and most likely your perspective as well, that appreciation does not reduce the passive investors capital account balance, it reduces their tax basis.
The capital balance is technically reduced by the distribution amount above the preferred return, which is a portion of the $1,400 in the withdrawals and distributions box. However, Ashcroft deals are structured in a way that the LP continues to receive a preferred return based on their original equity investment amount, with the difference made up at sale. So what that means is that anything above that $1,400 is considered a profit, and whatever the profit split is for that deal, say 70-30 or 50-50, at the end of the deal, once everything’s said and done, the total profits distributed needs to be 50-50 or 70-30 to the LP/GP. If the LP is receiving money during the hold period, and then the GP technically receives — let’s say, for simple numbers, the GP doesn’t receive any money at all from profits, then at sale, 100% of the profits have gone to the LPs, and the GP receives 0%. So after the equity is returned to the LPs, before the remaining profits are split, whatever the profit split is, the GPs need to catch up first. So the GPs are distributed until the profits are 70-30, as opposed to being 100 and 0.
So just to keep things super, super simple, let’s just say that the profit split is supposed to be 70-30, and then at sale, you add up all the different distributions that have gone to the LPs and you spend $100,000, and you add up all the different distributions that we have done to the GPs and it’s zero dollars. So 100% to the LPs, zero to the GPs. If the split is going to be 70-30, again, let’s just do even more simpler math. Let’s say that number is $70,000 instead of $100,000 just so I can simply explain this to you. So $70,000 to the LP, and zero to the GP at sale. So the way the waterfall will work is that, first the LPs equity will be returned; so whatever they invest, it will be returned, and then before the remaining proceeds are split 50-50 or 70-30, in this case, we’ll say 70-30, is a GP catch up. So it needs to be a 70-30 split. So the first $30,000 will flow to the GP, so that at that point, the LPs have received $70,000 and the GPs have received $30,000. Now they’re a true 70-30 split, and then the remaining profits are split 70-30.
So back to the taxes in the K-1. So the majority of the other items on the K-1 that are report on just flow through to your passive investors’ qualified business income worksheet, and the net effect of these items will be very unique to each investor based on their specific situation and other holdings that they have. So again, that’s something that would take a long time to explain because of all the different situations. So what’s important are the three main sections we talked about, which is box number two, the net rental real estate income or loss, and that is what is passed through as depreciation; so that is the depreciation deduction. Box number 19 is any positive distribution received, any cash flow sent to that investor, and then section L will give you the actual tax basis, which is whatever their capital account is, so their investment minus depreciation, minus distributions, and that’s what they are going to be taxed on.
Now if you want to learn more about each of the individual sections and boxes, you want to go ahead and check out the IRS’ website on the Schedule K-1. So if you just google ‘partners instructions for Schedule K-1 form 1065’, you should be able to find it and it’s got a bunch of hyperlinks, and go through every single item on that K-1. Or the website is irs.gov/instructions/i1065sk1.
As always, just to conclude again with the disclaimer, to better understand any tax implications on their investment, it’s always important to let them know that they need to consult with a professional like a CPA, a financial advisor and accountant before making any investment decisions based off of the tax benefits of investing in apartment syndications.
So that concludes this episode on how your passive investors will be interpreting their Schedule K-1 tax report. Make sure you download that free K-1 sample so that you can follow along, again, by either listening to episode again or hopefully you’ve been doing it while I’ve been talking. That’ll be in the show notes, also at syndicationschool.com along with all the past syndication school episodes, and previous free documents. Alright, that’s it for now. Thank you for listening. Have a best ever day and I’ll talk to you soon.
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