Private equity real estate transactions are unique for a variety of reasons, one of which is the tax advantages that they offer. To understand the advantages and how they impact individual investors, it is first necessary to understand how the transaction is structured and why this methodology is used.
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Private Equity Real Estate Transactions Are Typically Structured Through an LLC
The typical private equity real estate transaction is structured as a Limited Liability Corporation or “LLC” (as opposed to an S-Corporation), which is thought of as a “pass through entity” for tax purposes. Although the entity is technically a corporation, one of the benefits of the LLC is that it is taxed as a partnership, meaning income and expenses “pass through” it and go directly to the individual shareholders/investors who are responsible for claiming their share of income or loss on their own individual income tax return.
In a very simple example, assume that an LLC is formed to purchase a property with two shareholders who each own 50% of the company. The property’s income and expenses are recorded at the LLC level, but the tax liability is passed through to each of the two investors. If the property produces current year income of $100,000 before taxes, $50,000 will flow to each investor who will be responsible for claiming this amount on their individual tax return. The mechanism used to inform each shareholder of their tax liability is a document, produced at the LLC level, called a “Schedule K-1” that is required to be distributed to each shareholder.
What is a Schedule K-1 Form?
As part of filing their tax returns, multiple-member LLCs are required to file Internal Revenue Service (IRS) tax form Schedule K-1 each tax year. The Schedule K-1 Form is used to report each member’s share of the partnership’s income, loss, and deductions. Specifically, the K-1 Form is designed to capture things like real estate income, bond interest, royalties and dividends, capital gains, foreign transactions, and any other payments that a member might receive as part of their involvement with the LLC.
Again, the distribution of the Schedule K-1 passes the income tax liability through the corporation to the individual. The income, losses, deductions, and other items reported on the K-1 are included in each individual shareholder’s tax filing. This structure highlights one of the major benefits of using an LLC in a commercial real transaction. The LLC is allowed to book a certain amount of “depreciation” annually, which acts as a tax credit to offset the property’s taxable income. In some cases, the amount of depreciation causes the LLC to report a “loss” which is passed on to individual shareholders who can use their portion of the loss to offset their own taxable income.
Instructions for Schedule K-1 For Private Real Estate Investors
The LLC is required to distribute IRS Form Schedule K-1 to each one of its members. In turn, the individual is required to include the information from the K-1 as part of their own tax return filing. An example of a blank K-1 is displayed to the left and a series of instructions/considerations that individuals should take into account when filing one are below (NOTE: This article is for educational purposes only. For investors that are uncertain about the tax liability associated with the receipt of a K-1, they should seek tax advice from a qualified tax professional who is familiar with the specifics of the United States Tax Code)
Valuation of a Partner’s Share
While there is a lot of relevant information reported on K-1, one item that is conspicuously left out is the fair (market) value of the investment. Instead, the K-1 reports the tax basis of the investment, which is an IRS calculation that takes into consideration the initial investment, value-add improvements, and depreciation.
We always recommend that private real estate investors consult with their real estate and/or tax professional(s) to determine the value of their investment.
Types of Tax Basis
A property’s tax basis is the IRS calculated value of the asset, and it determines whether a sale of the property would result in a profit or loss. There are two types of tax basis typically associated with a private equity real estate investment, “Inside Basis” and “Outside Basis” and it is important for investors to familiarize themselves each of them to understand how partnerships and their distributions are taxed.
A property’s Inside Basis includes an adjusted basis of each partnership asset, and usually comes from partner contributions. The outside basis consists of each partner’s share in the LLC partnership’s interest and it can be quite different from the inside basis.
The calculation of both starts with the amount of each member’s original capital contribution. Additional contributions made over time and taxable income increase the basis while expenses, depreciation, and distributions reduce it. In addition, the Outside Basis is increased by each member’s share of the LLC’s liabilities, and is decreased by repayment of them. It is important for each member to understand and consider how each action affects their tax basis and tax liability.
On occasion, a Schedule K-1 will show a loss in business income due to tax deductions like depreciation.
For example, if the underlying real estate asset produces $50,000 in income in a given calendar year, but also qualifies for a $150,000 Depreciation deduction, the business will report a loss of $100,000. If there are two equal members involved in the LLC, each shareholder’s share on the Schedule K-1 form would state a loss of $50,000, which can be used to offset individual tax liability.
There are specific distributions that offer certain tax deferral advantages. For example, the IRS allows for certain earnings such as capital gains, dividends, and interests to be taxed when the member actually realizes the benefits of the distribution. For real estate investors, a classic example is when a distribution is made due to the refinancing of a current property. If a member has sufficient basis, this distribution will not be taxable upon receipt. Instead, the member’s tax basis is lowered by the distribution amount, and they will be caught up on their capital gains taxes when the asset is sold.
It is important to note that the IRS requires all taxpayers to pay a minimum amount of income tax each year. If this minimum requirement is not met, it is possible that a Schedule K-1 can trigger an Alternative Minimum Tax (AMT), which recalculates personal income taxes and can result in an individual having to pay much higher taxes than anticipated.
When are K-1s Due to Investors and Partners?
The deadline for businesses to distribute a Schedule K-1 to each member is March 15th or the 15th day of the third month after the entity’s tax year ends. But, it is common for an LLC to file for an extension with the IRS and delay sending out their Schedule K-1 forms until September. This is usually due to the complexity involved in filing partnership tax returns.
It is very important for each individual member to be in close contact with their investment manager(s) to determine the actual delivery date of their Schedule K-1 as it is not uncommon for them to be delivered as late as September. For this reason, investors may also need to request an extension of their own personal tax return to avoid a failure to file penalty.
It should be noted that it is common for an individual investor, especially the wealthy ones, to have many different types of investments, each of which are required to supply a K-1. So, an individual investor with a large private investment portfolio could receive dozens of K-1’s each tax year, which can make the filing of their own taxes fairly complicated.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
As part of our year-end accounting practices, we work with our tax preparer who uses specialized tax software to send all of our investors the required documents for each one of their holdings with us. If you would like additional information about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.