Everything You Need To Know About K1s
Running a fund or real estate firm brings with it many responsibilities, like choosing the right deals for your LPs, and making them enough money back on their risked capital. But it also means other financial and legal obligations, like handling some tax aspects for them. Schedule K-1 is one of them. What are K1s? When do K1s need to be issued? How can a GP create a K1? Get answers to all of these questions – and more – below.
What are K1s?
You might’ve heard it being called by a similar name: IRS Schedule K, but they are indeed the same. However, this IRS tax form comes in two variations:
- Schedule K-1 (Form 1065), Partner’s Share of Income, deduction, credits, etc.
- Schedule K-1 (Form 1120S), Shareholder’s Share of Income, deductions, credits, etc.
- A partnership reports transactions via Form 1065.
- An S corporation reports activity via Form 1120S.
Usually, these are pass-through entities that aren’t required to pay corporate taxes themselves due to passing profits on to their investors, like your LPs. Both of these forms are federal tax documents issued annually, and they report the gains, losses, earnings, dividends, interest, and other distributions from certain investments or business entities for the previous tax year.
As a veteran GP, you know that Schedule K-1 is prepared for each individual partner and is included with the partner’s personal tax return, but It’s important you remember:
- Your LPs will use Schedule K-1 to report their earnings, losses, and dividends.
- Your LPs will expect you to use Schedule K-1 to track each LPs share/ownership in your fund.
- Schedule K1s are often issued by pass-through businesses or financial entities which don’t directly pay corporate tax on their income. Instead, they shift the tax liability to their stakeholders or partners. This is what your fund will do.
Understanding Schedule K-1
The U.S. federal tax code allows the use of a certain strategy called “pass-through”. This strategy, in certain cases, lets a trust or a partnership shift its tax liability to the (often many) individuals of interest participating in it.
In such a scenario, the entity itself, let’s say, your fund, pays no taxes on its earnings or income.
Instead, any payouts, along with any tax due on them, are “passed-through” directly to your LPs.
And this is where Schedule K-1 comes in.
Its purpose is to report each participant’s (LPs) share of the business entity’s (fund) gains, losses, deductions, credits, and other distributions (even if you didn’t actually distribute them).
Note: K1s are not filed with each LPs tax return, but the financial information posted to each LPs K1 is sent to the IRS using Form 1065. Basically, RELPs (real estate limited partnerships) don’t pay taxes directly. Instead, their net losses/gains are pass-through income to each partner.
As you know, your LPs are able to enjoy tax benefits as if they were investing in CRE on their own. Things like depreciation and interest expense can be deducted to reduce each partner’s tax liability, and use 1031 exchanges for similar property buy-outs in order to defer their capital gains.
However, remember that your LPs aren’t able to exchange their partnership interest, meaning—your LPs will have to pay capital gains tax if your partnership with them dissolves—even if they wish to reinvest the capital.
In your partnership with your LPs, they are only liable for the debts and obligations based on the amount of capital they contributed (risked), while also taking into consideration the partnership agreement (contract) signed (how the partners split profits)—which impacts the info on their K1s.
What is distribution income in K1?
It’s important to note that while a K1 shows the reportable results concerning your fund’s earnings, it doesn’t mean you’re obligated to pay out each LP the amount of earnings listed. For example, your fund may choose to retain earnings in the business; for reinvesting purposes, for example, and pay less to investors and owners—as long as it’s agreed upon in your initial contracts.
How general partnerships file K1s
As mentioned, in general, partnerships by themselves aren’t liable for taxes on income generated by the business. Instead, each of your LPs is subject to income taxes based on their ownership percentage in your fund.
When you’ll file 1065s to the IRS outlining your fund’s finances, you must also prepare a K1 for each LP to reflect their share of any profits/losses/distributions from the business. When your LPs receive their K1s, they’ll include the information on their personal tax return for the year.
So, for example, if your fund generated $250,000 of taxable income in a year, and your LP owns 50% of the fund, you’ll generate a K1 for them lining a $125,000 share of that income. The amount of tax they owe will be based on their overall federal income tax bracket for the year.
What to know about the Capital Account section of the K-1 form
The Capital Account section of the Schedule K-1 reports changes to your investor’s (LPs) capital/equity in your fund, including capital contributions and allocation of net income or loss, among other things.
What confuses most GPs is the tax basis box, and it’s designed to differentiate which capital method is being reported.
If they don’t check the tax basis box, they’ll need to track their tax capital separately each year.
If they do check the tax basis box, the LPs Schedule K-1 is reported on a tax basis, and the K1 reported amount is added to the liability allocations to calculate the overall tax basis in their investment.
When is Schedule K-1 due?
When it comes to K1s, your duty to your LPs is to prepare them and make sure they’re received no later than March 15th (or the third month following the end of the fiscal year). These forms are notoriously late and are prone to cause issues—with March 15th being so close to the tax filing deadline (April 18th). If you’re going to be late in providing your LPs with their K1s, make sure they know in advance, and suggest they file for a tax extension. If your LPs file their taxes without their K1s, they’ll have to amend it and refile. Help them by preparing their K1s on time.
Note: if your LP files for a tax extension, it’ll only delay their filing, not them having to pay taxes they might owe).
Your investors chose you and your fund for many reasons, but all investors like peace of mind, especially when it comes to taxes. Today, by educating yourself on what are K1s, understanding them, learning who files them, when they’re due, and your obligations on the matter, you gained paramount knowledge on how to help your LPs maintain/gain that peace of mind.
Investing in commercial real estate can be risky. It is not a fit for everyone. While we aim to provide general information to help you better understand CRE investments, we are neither providing any investment advice nor advising for or against any particular investment.