One of the greatest, yet least understood benefits of investing in private real estate is the tax treatment of distributions. In direct ownership of real estate, distributions from operating proceeds are not taxable. Instead, each partner’s proportionate share of profits (losses) is reported for tax filing purposes, and this number is sheltered through the deduction of non-cash charges such as depreciation. Compared to other dividend or yield producing investments, real estate therefore often produces a more attractive after-tax return.
The Schedule K-1 is a piece of IRS Form 1065 US Return of Partnership Income that reports each partner’s share of a partnership’s profits, losses, deductions, and credits to the IRS. Partnerships do not pay taxes directly to the IRS. They are structured as “pass through” entities, meaning that all profits and losses of the business flow directly to the individual partners and the individual partner’s proportionate share is then reported on their individual income tax return.
The Schedule K-1 has three sections:
- Part I reports Information about the partnership.
- Part II reports information about the individual partners and their respective ownership position.
- Part III reports the partner’s share of current year income, deductions, credits, and other items.
While all information reported on a Schedule K-1 is relevant to the IRS, a few sections are particularly relevant to the beneficial treatment of distributions in direct real estate investment.
Part II Section L: Partners Capital Balance Analysis reports the partner’s tax basis in the partnership. Your capital balance begins with your original contribution to the partnership. It is increased by future contributions and by any taxable income allocated to you over the year. It is reduced by any taxable losses and is further reduced by your share of any distributions.
It is important to note that the ending capital balance on your Schedule K-1 is your tax basis in the partnership at the end of each year. This is relevant because if you were to liquidate your partnership interest, you would subtract this number from the sales proceeds received on liquidation to estimate the capital gain on the sale. If the ending capital account is negative, it is added to the proceeds received to estimate the capital gain.
Part III, Section 19 reports the distributions paid to the investment partner during the year. The money used to fund these distributions generally is generated from the net operating income of the partnership. These distributions are not reported as taxable income on the individual income tax return during the year. It is simply carried to Part II, Section L, and reduces the tax basis of the partnership as previously discussed.
Part III Section 2 reports the partner’s share of net rental real estate income (loss) for the year. This is the partner’s share of all revenues, less operating expenses and depreciation deductions for the year. The depreciation deduction is subtracted from the net operating income of the partnership to arrive at the net rental real estate income (loss), and this is allocated proportionately to each investor and is reported on the individual’s income tax return.
In many cases, the partner’s share of net rental real estate income (loss) is substantially less than the distributions paid during the year. This is the result of the accelerated depreciation deductions allowed by the IRS with regard to rental real estate. The depreciation deduction is one of the largest benefits of direct ownership in rental real estate. While property usually increases in market value each year (appreciation), the cost to purchase residential real estate can be written-off as depreciation over a 27.5-year life, providing a substantial benefit to the investor.
This article has covered a few sections of the annual schedule K-1 that are most important to the rental real estate investor. To fully understand how investments in rental real estate impacts your personal tax situation it is important to consult with a CPA or other tax professional.