High level of taxes for syndication

[Rud Sev]

Hello,

I am new to the world of syndication (LP investor) and want to understand how taxes at a high level for syndication as LP before asking individual specific questions to my CPA.

Notably, I want to understand how preferred returns/cash flows are taxed, if at all, until the amount invested has been returned. I could not find the answer I'm looking for when searching.

The following example could be used:

- Amount invested $100k

- Preferred return (5 years): 8% or $8k

- Disposition (Sale) (Year 5): $200k

This simple example assumes no cash flow beyond the preferred return, no cost segregation/bonus segregation, and doesn't take depreciation into account.

Would the first 5 years of cash flow (preferred return) not be taxed, and only the remaining amount on the disposition would be taxed (e.g. $200k - $100k + 5 * $8k = $140k)?  Would the federal tax liability be $140k at year 5 for the sale, with long term capital gains (ignoring any Net Investment Income Tax)?

If there is a good post or article regarding this topic, I'd be happy to read it. Thank you!

[Evan Polaski]

@Rud Sev, I would ask the syndicators you are considering if they have any sample K-1s they have issued in the past to try to get a general idea of how they treat their common taxable items.

There are a few things that are likely needed to be outlined:
Your capital account balance for the investment, i.e. how much money the syndicator is saying you have outstanding at any time and used to calculate preferred returns, can vary from your taxable capital balance shown on K-1.  My next comments are ONLY for tax purposes and may not align with how the waterfall works in the offering.

Your syndicator may treat all distributions paid to you, up to your full capital balance and any allocated debt, as a return of capital for tax purposes.  This is often shown in the distributions box, and reduces your taxable basis in the deal.  Net effect, typically, means distributions are not taxed in current year, but do lower your basis resulting in larger tax bill upon sale.

Depreciation reflected in the net gain/loss from rental box on K-1.  As noted in articles Michael noted, this may or may not have any real impact on your taxes, depending on if you have any other passive gains/income to offset.  Net losses here also reduce your taxable basis making sale gains larger from a tax perspective.

If you don't have any depreciation, you can owe taxes on the net rental income, even if no distributions were made to you.  If syndicator is building reserves for the first year of ownership, for instance, and not paying distributions, AND recognizes rental profit, you will have a larger tax bill that year, since you "made money" in the IRS's eyes, even though you did not receive any cashflow from your syndicator.

On a more general note, a preferred return does not mean you will get that amount of cash flow each year.  It is simply a return threshold that needs to be hit before the GP can share in any profits above that level.