By Brandon Hall, CPA | August 17, 2021
You invested in a syndication, fund, or decide to go into business with a friend. An LLC is formed and all activity for the partnership is reported on Form 1065. You are then sent a Form K-1 reporting your share of the partnership’s activity.
How do you know the Form is accurate?
And how do you report the information on your own tax return?
It’s important that you know the answers to these questions because the reality is that many tax preparers struggle with partnership tax law and IRC Sec. 469 (the passive activity Code section).
Click this link to walk through Form K-1 with us: https://www.irs.gov/pub/irs-pdf/f1065sk1.pdf
What’s on Form K-1?
Form K-1 will report information about the partnership and you, the partner.
In Part II of the Form K-1, you’ll see your information and it’s important to double-check this information against any agreement you have with the partnership.
For example, you’ll want to make sure that Section J is correct… does your profit % match the operating agreement you signed?
You’ll also want to make sure that Section L accurately documents any contributions (cash or property) you made to the partnership and any distributions you received from the partnership. Tracking Section L is critical to protecting your investment because it tracks your total capital ultimately payable to you. You don’t want to end up getting short-changed whenever the partnership closes down.
Part III of the K-1 reports the partnership income and loss, any “guaranteed” payments (think of this as salaries), and other income items such as interest, dividends, royalties, and capital gain/loss. Amounts in this section are your share of the total amounts reported by the partnership.
Your K-1 may also come with statements that add additional detail. This is especially true when there are amounts or information entered in Box 20 of the K-1.
Common Issues
K-1s are meant to make it easy for partners to report their share of partnership income on their own tax returns. Unfortunately, tax preparers lacking experience in partnership tax law and the passive activity rules can cause a mess. Here are common issues and mistakes we see preparers make:
- Incorrectly applying the passive loss rules. We sometimes see preparers make the mistake of thinking that the passive loss rules apply to certain boxes of the K-1. For example, a preparer may think that because there’s an amounts reported in Box 2, it’s passive. Or because there’s an amount reported in Box 1, it’s non-passive. What’s really going on here is that the preparer doesn’t understand IRC Sec. 469 (the passive activity rules). The K-1 simply reports a partner’s share of income or losses. The partner must then apply the passive activity loss rules to the amounts listed on the K-1.
- There can be an amount reported in Box 1 (Ordinary business income/loss) and that amount can be passive.
- There can be an amount reported in Box 2 (Net rental real estate income/loss) that that amount can be non-passive.
- Don’t make the mistake of thinking that just because an amount is reported in Box 1 or 2, the activity is automatically passive or non-passive. You have to analyze whether or not the partner materially participated in the partnership. If they didn’t, all amounts are passive regardless of where they are reported on the K-1.
- Incorrectly classifying non-recourse debt. For most real estate partnerships, Section K of Part II of the K-1 should not list non-recourse debt. Instead, there should be amounts listed as qualified non-recourse debt or recourse debt. Qualified non-recourse debt will give a partner basis to take tax losses even if their capital account would otherwise go negative. A discussion on qualified vs non-recourse is beyond the scope of this article.
- Poor capital account tracking. When a partnership ceases operations and pays all the partners out, how does it determine how much each partner should get? By looking at ending capital accounts. Make sure your are tracking yours even if it’s not reported on your K-1.
Where is a K-1 Reported on Your Individual Returns?
K-1s are reported on Schedule E, Page 2. They will be listed on that page and will clearly show which K-1 activities were passive and non-passive.
You may have many K-1s and may need to review an attached statement to see all of the K-1 activities you hold a stake in.
K-1 activities that you are passive involved in will flow to Form 8582 where they will be netted against your other passive activity income or loss.
Takeaways
Form K-1 summarizes a partnership’s activity on a per-partner basis. It will show an individual partner’s share of the partnership’s income and losses.
It’s extremely important to remember that the passive activity rules are applied per partner and to the entire activity. The partnership can report a large “Ordinary business loss” in Box 1 but that loss could still be passive to you if you did not materially participate in the activity.
Alternatively, the partnership could report a large rental loss in Box 2, but that loss could be non-passive to you if you are a qualifying real estate professional under IRC Sec. 469(c)(7) and if you make the grouping election under Treas. Regs. 1.469-9(g).
Watch for non-recourse vs. qualified non-recourse. If you are in a real estate partnership and you are allocated a share of the debt, you should most likely be allocated qualified non-recourse instead of non-recourse debt.
