Estimating Schedule K-1 as LP prior to investing?

Question

I'm trying to track down some real world numbers or estimates of Schedule K-1 statements beyond the high level handwaving on Investopedia and the like. I'm going to make a huge number of assumptions and I want to be told which assumptions are wrong and what the right way of looking at this is.

Say I invest in an apartment syndication or storage unit or mobile home park or something like that. In this example, the GPs aren't going to do any accelerated depreciation via cost segregation.

I see from the investor summary that the acquisition fee of the unit is $20M. I invest $100K in it as an LP, giving me a 0.5% share of the property.

The investor summary predicts the following NOI:
Year 1: $1M
Year 2: $1.25M
Year 3: $1.5M

So given my 0.5% ownership stake, does that mean I would be receiving a K-1 showing my income from this as:
Year 1: $5,000
Year 2: $6,250
Year 3: $7,500

If we continue the example and say that I receive an 8% dividend each year, then my actual profit each year would be:
Year 1: $8,000 - $5,000 = $3,000
Year 2: $8,000 - $6,250 = $1,750
Year 3: $8,000 - $7,500 = $500

This tells me that I must be missing something incredibly fundamental in all this -- that one of my assumptions is so egregiously wrong that it invalidates literally everything else.

But what? And how can I estimate the K-1 before actually investing in the property and locking me into a 5-10 year investment?

Brian Burke · Answer

@Kurt Granroth, the investment prospectus from most sponsors don’t address the tax issues because everybody’s tax situation is different, and most sponsors aren’t tax experts that are qualified to give tax advice. Neither am I, but I’ve been doing this long enough to know the answer to your question.  But, I still have to preface this with the advice to consult your tax advisor for specific tax counsel.

So here goes. Income and distributions are two completely different things. Income is taxable, distributions are not. Think of it like a savings account—you pay tax on your interest, not your withdrawals.

Net Operating Income and distributions are completely unrelated. You can have positive NOI but negative cash flow (think:  debt service and an unexpected roof replacement costing more than the NOI throws off).

Taxable income, which is shown on the K-1, is NOI minus loan interest, minus depreciation and amortization, minus partnership level expenses (such as sponsor asset management).

So if you want to estimate the income that will show on your K-1, take the forecasted NOI, subtract loan interest (not the principal payment), subtract depreciation (take the purchase price, multiply that by a decimal that is the the ratio of structures to land assessed value on the property tax bill (usually between 0.6 and 0.8) then divide by 30), then subtract amortization (nearly impossible to predict, if you ignore it you’ll just get a conservative estimate of the taxable income).  Next, subtract the estimated partnership expenses. Then multiply that result by your ownership percentage. Bingo!  There’s your estimate.

In most of my syndications the taxable income has been near zero in the first couple of years (we do cost seg so that juices it but even without cost seg the taxable income should be fairly low thanks to standard depreciation).  In almost every case I can recall, taxable income was less than distributions throughout the hold period.  In many cases, far less.

Your K-1 will also show your distributions, but it has nothing to do with taxable income, it is just to show your capital account. So if the investor waterfall is an 8% pref, for example, you get 100% of the cash flow until you’ve been distributed an 8% cumulative return. This depends on how much cash flow is available to distribute. So maybe you get 4% in year 1, 8% in year 2, and 12% in year 3. That adds up to an 8% pref.  That said, this has nothing to do with taxable income nor your tax liability.

John Woodrich · Answer

This isn't going to be long because carpel tunnel is kicking my @$$ right now.

The details matter quite a bit.  In many of these situations the first year shows a K-1 loss and some investors may get a distribution.  In your example above (with many assumptions and flaws), you are showing a loss of -$1,328.  The reason your individual tax situation matters is likely because this is a loss that is not deductible to you as a passive loss.  However if you had passive income that offset it you would have gained a tax benefit of $1,328 * (insert your marginal tax rate).  At the same time, the company may have kicked you a distribution.  You may ask - how can the company kick me a distribution if it had a tax loss....  Well, that is because there were non-cash items that caused the loss (depreciation/amortization) and the company had positive cash flow.  This distribution to you would not be taxable, it would be a return of capital.  So to summarize, if we said the cash distribution to you was $6k your capital account would be as follows:

Beg capital                           $0

Cap Contributed         100,000

Loss allocated               (1,328) possibly receive a deduction

Distribution                   (6,000) not taxable

Ending Capital         =     92,672

Depending on the deal you are in you may get a preferred return as mentioned above but that will depend if everyone in the deal is throwing in cash.  This only complicates the matter and a waterfall calculation is completed to determine in the income allocation taking into account the preferred return.  This is fairly common in investments where there are service partners and capital investors.  These can get very complicated from a tax perspective and hopefully your company Schedule K-1s are not coming from H&R Block.

Partnerships have a lot of flexibility however with that they can easily become the most complex operating entities.  For each opportunity there is a tax trap.

To sum this up, you want to understand all of this but most people who major in accounting taking 5 years of college do not understand this leaving school.  Many who do not bury themselves in partnerships struggle to grasp this also.  I don't know what your day job is but if you try to take all the experience you have learned through your career and someone like me asked a question about explaining it you will understand what you are asking.

What has been posted is enough to be "dangerous," if it wasn't tax season I may be up for a phone call to discuss your concerns further.

If you are interested in investing in a syndication and the tax treatment is a material matter I would question whether it is a good investment.  If you make money it will generally be taxed.  if you lose money you may get a tax benefit but you would rather make money an pay tax than lose money and receive a benefit.  Focus on finding an investment that makes money and deal with the taxes when they come.

Michael Plaks · Answer

@Kurt Granroth

I will give you an honest answer which you don't want to hear: there is no way to estimate what you want to know.

NOI is a hypothetical number used by syndicators to attract investors. Depending on their experience and integrity, this number may or may not be close to the real NOI for the project. If well estimated, this number can somewhat predict the performance of your investment.

However, even if very carefully estimated, NOI cannot predict your share of taxable income (or loss) that will end up on your K-1. Why? Not only because NOI does not include several major deductions, but because many important decisions will be made between your GP and their CPA during tax preparation. Such as which costs to deduct and which to depreciate, etc.

Basically, you have to make your decision without a reliable indication of how it will affect your taxes.

Todd Dexheimer · Answer

Your shares should be based on the total investment dollars needed. If the Purchase is $20mm and the down payment and closing costs, plus repairs in 30%, then the down payment/costs would be $6mm.

If this is a $20mm cash purchase, then your $100k is .5% ownership share. If you get paid out an 8% preferred return, then your income will be based on that ($8000) less any depreciation. With the example you gave, there will not even be 8% made on the deal until after year 3, so you taxable income will the the profit you show each year.

Brian Burke · Answer

@Kurt Granroth I think your computation is accurate.  In reality the taxable income would be less than -$1,328 because there would also be amortization of fixed assets and probably some partnership-level fees such as an asset management fee.  But in general, I think you're on the right track.  One side-note, the number on your K-1 will be -$1,328, not -$80,000.

As to the advice to get advice from your personal tax advisor, that comes primarily because most of the people on this website aren't qualified to give tax advice and shouldn't be purporting to be qualified to do so.  And even if they were, they don't know your complete income and tax picture.  Thus, you will often see people (myself included) preface their opinion with that disclaimer.  Your personal tax situation does play a role here as these are passive losses and there might be limitations on using passive losses to offset other income, which means that the loss on your K-1 might not be the amount of your deduction.

Account Closed · Answer

I think your rep who is showing you that opportunity should be able to show you sample K1s or give you this information on the deal you are looking at.  If they are not or an not ... find someone else.

Ivan Barratt · Answer

@Kurt Granroth thanks for the kind words! Remember to vote for posts you like! ;)  I'll email you to discuss further but all in all I think you're getting good info here and your recent scenario looks sound.

Kurt Granroth · Answer

@Ivan Barratt - you are to blame for my descent into the K-1 details as you showed me just how little I knew about the topic but how critically important such knowledge is!  Did I say "to blame"?  I mean "to be eternally thanked!" :-D

Let's talk, then about the difference between the taxable income on the K-1s and the possibly non-taxable distributions, which are completely different things.  @Brian Burke and @John Woodrich, you have both stated or reinforced this point.

The thing is, I know NOTHING about that.  I read everything I could on BiggerPockets on syndications (including such articles as "The Compelling Tax Benefits of Real Estate Syndication") and searched on the wide web and nothing even hints at how a cash distribution (what I often hear referred to as a "dividend") is anything but taxable income like you'd get on a 1099-INT or 1099-DIV.

So what is a distribution if it's so independent of the taxable income?  And if this is too big a topic to answer in a forum post, then please point me to any articles that talk about this in any detail on the subject because this seems like very fundamental knowledge!

Kurt Granroth · Answer

I'm getting fantastic answers to my questions, here -- thanks everybody!  But for every question answered, I find myself with a cascading set of even more questions!  I thought I knew the basics of all this but clearly I'm far from that!

So if I ignore all of my other questions and concentrate just on estimating the taxable amount that could be stated on a K-1, then does this look like it's even in spitting distance of what could happen?

$20,000,000 acquisition price70/30 loan$6,000,000 down payment$14,000,000 loan @ 5% amortized over 25 years$100,000 investment1.66% shareYear 1:NOI: $1,000,000Mortgage Interest: $680,000 (from calculator)Depreciation: $400,000 (($20M * 0.6) / 30)K-1 Taxable Income: -$80,000My Share: -$1,328

Is that even a tiny bit accurate (even given fake numbers) or, if not, is it obvious what fundamental thing I'm still missing?

Then, both @Brian Burke and @Ivan Barratt have made mention of my own tax advisor and I'm not understanding why.  What does my personal tax situation have to do with a K-1 at all?  Wouldn't the K-1 be based exclusively with my investment in the property itself and thus would be created by the GP completely independently?

John Woodrich · Answer

For the most part, what @Brian Burke says is correct however some distributions can be taxable.  Not likely in the beginning.

This is tax season and the corporate tax deadline is in 10 days, Brian's answer is likely the best  you will get before summer.

At the end of the day you likely won't have enough information to predict this.  The best you can do is understand what is going to be taxable and what isn't and base you decisions accordingly.  Or bug your CPA but if you are just tire kicking do it in May.

Estimating Schedule K-1 as LP prior to investing?

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