Oct 12, 2023
As a fund manager, you likely receive a Schedule K-1 form (K-1) annually from you underlying fund assets, but do you know how to read and interpret that document? Understanding your K-1 is important to accurately filing yourfund’s annual income tax returns and can be helpful in making tax planning decisions with your CPA. This blog post will give you a crash course on the K-1. Make sure to consult with your tax professional if you have questions about your K-1 or other tax related matters.
A Schedule K-1 is a federal tax form for business partnerships that reports each partner’s share of the entity’s income, gains, losses, deductions, and credits for the current tax year. The partnership provides a copy of the K-1 to each investor and a separate copy to the IRS. To accurately file your annual income tax return, you are required to report the information from the K-1 and its supporting statements. In addition, the K-1 reports important tracking items, such as the partner’s share of liabilities, and tax basis capital each year. Your CPA will use these items for tax planning with you.
Interpreting the information on your K-1 can seem daunting, but these tips will help you increase your understanding of the document. First, familiarize yourself with the different sections; the far-left section is divided into Part I and Part II. Part I is information about the partnership filing the tax return. Part II reports the basic, informational items about the investor. You, as the recipient, should review this annually with the help of your tax professional to ensure the correct information is being reported. Part III can be divided into two segments. Lines 1-13 are your allocable share of the business’ taxable income. Line 1-11 are your income items, and lines 12 and 13 are your deduction items. Lines 14-21 are informational items, and as mentioned before can have an impact on your respective fund income tax return.
In addition to the K-1, several pages of statements are typically included with the K-1 package. These statements are generally added to provide the partner with adequate information and disclosures to file their respective tax returns. It is key not to disregard these statements and your CPA can help you interpret these statements as well.
As previously mentioned, each partner’s share of the partnership’s income must be reported. Code Section 702 establishes a list of items that must be separately stated reported:
• Net short-term capital gains and losses (box 8 on the K-1)
• Net long-term capital gains and losses. (box 9)
• Section 1231 gains and losses, (box 10)
• Charitable contributions. (box 13A)*
• Taxes paid to a foreign country or to a U.S. possession. (Line 21 and Schedule K-3)
• Any other items provided by the Regulations.
It is important to be able to interpret these separately stated items, since all these items may be taxed at different rates compared to ordinary income. You should work with your CPA to determine how your K-1 should be completed based on your specific situation.
Another key item to decipher is the difference between box 1 and box 2 on your K-1. Box 1 represents ordinary income or loss. This is income and loss that derives from the partnership’s trade or business. If the business is a hotel, this is the annual income and loss from hotel-based activity. Box 2 represents income and loss from rental activities. This is the annual income and loss from rents and rental related deductions. In your respective K-1 you may have both boxes populated depending on the underlying asset.
The K-1 also reports informational items for the partner, such as alternative minimum tax (box 17), tax-exempt income (box 18a),* non-deductible expenses (box 18c),* and distributions (box 19). These items could have an impact on your fund’s tax return and they provide information about the performance of the investments.
Understanding your K-1 is a critical part of analyzing the success of your tax profile within your fund. With diligent planning and the assistance of tax professionals, you may be able to use your investment income or gain to pair with other investment gains or losses. This is an easier task once you understand the various characteristics of income being generated. You can track tax basis and your allocable share of liabilities in an effort to prevent losses limited or income recognition events upon distribution.
The K-1 may appear hard to interpret, but with a little effort, the statements can add value to your understanding of your real estate investment portfolio. Having the right knowledge about this form can give you peace of mind when filing your fund’s taxes. The tips provided here should not be taken as legal or tax advice. Always make sure to consult a tax professional if you have any questions about any of the items on your K-1.
*Consult with your tax professional for a more detailed explanation of the subcategories for each box mentioned above.
Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include, but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions.