Explained: Tax consequences of K-1 syndications

[Michael Plaks]

Introduction

This complex topic has been discussed on many BP threads, with persistent misunderstandings and misrepresentations. Many investors fail to grasp the fundamental principle of taxation: you cannot, based on your personal experience, say: "This is how it works." You can only say "This is how it worked FOR ME." Because taxes, especially in real estate, are so ridiculously complicated that your mileage will almost always vary. It makes taxes either exciting (for CPAs and a few tax nerds among investors) or maddening (for everyone else).

Syndication primer

I will describe a hypothetical syndication for a value-add apartment complex. Don't analyze my numbers as pro forma, they are merely to illustrate some taxation rules.

Year 1. You invest $100,000 into a syndication that buys a $10M apartment complex. Occupancy is low, and there's a lot of deferred maintenance. There is no cash flow and no distributions. The syndication reports a $10,000 loss on a K-1 (Box 2) as your share of the overall losses.

Year 2. Major capital expenses to rehabilitate the property. Still no cash flow and no distributions. The syndication reports another $20,000 loss on a K-1 as your share of the overall losses.

Year 3. The property is stabilized. Occupancy and rents are up, operating expenses are down, and there is finally positive cash flow. You receive a $15k cash distribution. Somehow, your K-1 says that you still had a $5k loss. Hmm, whatever.

Year 4. The property is sold for a sweet $20M. You receive a $200k cash distribution. However, your K-1 says in Box 10 that you had a $150k "section 1231 gain", as well as a $10k "unrecaptured section 1250 gain" in Box 9c. Fascinating, I know.

How we'd want it to work (spoiler: it doesn't)

Year 1: no cash = no taxes
Year 2: no cash = no taxes
Year 3: $15k cash is a partial return of the $100k investment = no taxes
Year 4: $200k cash is split into $85k remaining initial investment, and the other $115k is a capital gain taxed at 15%.

This would be simple and fair. Which automatically guarantees that it's against the IRS rules. IKR. The IRS wants you to ignore cash distributions and use K-1s instead.

How we would've agreed to interpret those K-1s

Year 1: $10k loss = $10,000 deduction
Year 2: $20k loss = $20,000 deduction
Year 3: $5k loss = $5,000 deduction
Year 4: $150k section 1231 gain = $150k long-term capital gain at 15%

First, it's fair. $35k total deductions offset by a $150k gain results in a $115k net gain - the same gain that we calculated based on cash. Second, it's actually better than the cash-based calculation. This is because we could take deductions against the regular income, and take them in years 1-3, while paying the tax in year 4 and at a lower capital gain rate. Win for us, yay! 

Unfortunately, the IRS does not want you to win. This tax treatment will not work for most investors, and for more than one reason.

Why you usually cannot deduct the K-1 losses

You probably know that if your family income is above $150k, you cannot take losses from passive investments. Coincidentally, most investors who have $100k in cash to invest in syndications tend to also be high-earning professionals, way above the $150k threshold.

Ahh, but you probably heard that if your income is below $100k, then you can take up to $25k of passive losses. Enough to absorb the losses from our syndication example, it seems. Before you congratulate yourself for not making $100-150k, I have to burst this bubble. You cannot take passive losses from K-1 syndications regardless of your income, even if it is below $100k.

There's some small print in the passive loss rules. And it mentions that you must pass the "active participation" test in order to take this $25k loss allowance. In an even smaller font, it says that you must own at least 10% of the investment in order to qualify for active participation. If you're a less than 10% partner in the syndication - game over, you lost.

But what about our beloved "Real Estate Professional" status? It's possible, but it's a long shot. In addition to the standard complications of qualifying for this status (no full-time W2 job, 750 hours etc), you cannot become a REPro from syndications alone. You might be able to pull it off if you're an active realtor or if you have other real estate investments that you own directly or if you run some other real estate business. This gets real complicated, so consult a reputable expert if you want to try this route.

What happens with these losses if they are not deductible?

They are on layaway until the syndication sells the property. In our example, in year 4 you will have two tax events on the same tax return: a capital gain of $150k plus a catch-up deduction of $35k from the prior 3 years of "suspended" passive losses.

Like in fairy tales (such as TV crime dramas), it all gets settled. Eventually. 

Didn't we forget about the $10k "unrecaptured section 1250 gain"?

Yes and no. This $10k in Box 9c of your K-1 is not some additional income. It is actually included in the $150k "section 1231 gain" from Box 10. So we already counted it. 

However, this number is still meaningful, and in a sneaky way. It makes $10k of the $150k taxed differently. Normally, $150k of Section 1231 gain would be taxed under the long-term capital gain rates of 15% (which, by the way, can be even lower - or it can jump as high as 24%, depending on your overall income.) 

The "unrecaptured section 1250 gain" portion represents what we casually call depreciation recapture. It is basically a reversal of the previously taken depreciation deductions. It is taxed at rates higher than long-term capital gains rates, at the ordinary income rates, albeit capped at 25%. And 25% is worse than 15%. Trust me on this, I'm an accountant.

But cost segregation is the magic bullet!

Cost segregation can indeed create huge tax deductions in the right situations. Syndications are not always the right situations, however. 

In our example, cost segregation might have increased your 1st year loss from $10,000 to maybe $50,000. If you can deduct it, it's good news. But if you cannot deduct a $10k loss (see above as to why you may be out of luck), then you won't be able to deduct a $50k loss, either. 

Besides, even if you're able to take the full $50k deduction, this extra $40k worth of depreciation will have to be returned to the IRS in Year 4. Instead of $150k gain, your K-1 will report $190k, of which $50k will be depreciation recapture.

If this is not complicated enough for you yet - keep in mind that cost segregation might trigger yet another kind of recapture, taxed even higher. (If you care to know, it's called Section 1245 recapture.)

And you're going to share the cost of the cost segregation study and more complex tax returns. 

To be clear, I'm NOT rallying against cost segregation for syndications. There're situations when it makes sense. But not always.

So, we're stuck with this odd and unfriendly tax treatment of syndications?

Not necessarily. My example was in a vacuum. It applies to someone who has only W2 income and only one syndication investment, and a syndication with the financials similar to my primer.

Any of the below can dramatically change the outcome:

• your syndication performs differently
• you're the syndicator/sponsor
• you have other syndication investments
• you own other real estate directly, not via syndications
• you run or invest in other businesses
• you qualify as a real estate professional
• you have unused passive losses from the past
• and this list can continue

But wait, there's more!

Multiple other complications are possible. For example, sometimes, in addition to the numbers mentioned on K-1s, you have an additional gain or a loss in the final year of the syndication. The technical term is "disposition of partnership interest."

Then there are other weird issues like QBI (qualified business income) deduction or business interest limitations or Section 179 limitations, and the list goes on and on.

In closing

As one contemporary political persona likes to say, I'll circle back. Back to the beginning of this post.

Which said: your mileage is likely to vary. Have your accountant analyze your particular situation if you want to know how syndications might affect your taxes. Otherwise, all you know is how someone else's taxes might be affected by that other person's investments. Not very useful information, IMHO.