This two-part series, brought to you by CrowdStreet and Trent Baeckl, CPA, walks new real estate investors through the tax information you can expect to receive in the coming months.
Tax reporting for direct real estate investments is not as simple as other forms of investments, such as stocks, and nor even as straightforward as other forms of real estate securities such as real estate investment trust (REITs). The good news is that the tax benefits of investing directly in real estate can be considerably greater than other types of investments, making the paperwork worth it. In this article, we’ll walk you through what you need to know about correctly incorporating a direct real estate investment into your tax return and highlight the generous tax benefits offered to direct real estate investors.
Let’s begin by talking through the tax information that’s necessary to parse through in advance of filing your tax return. First, while real estate investments can take many different forms, a common investment practice is for multiple individuals to come together in either a limited partnership or a limited liability company (LLC) and invest in property. LLCs are required to report to each investor financial information to determine the impact of your investments on your individual income tax return. This reporting occurs on Schedule K-1. The information reported includes your share of the net rental income, capital and liabilities of the LLC.
Net Rental Real Estate Income (Loss)
In order to allocate each investor’s share of the net rental real estate income or loss for the year, the LLC must first calculate the overall net income or loss by determining what is allowed under the Internal Revenue Code (IRC). Taxable income is generally calculated by taking net operating income and deducting interest and depreciation for the year. (The key deduction to remember is depreciation, which will be discussed in part two of this series). Taxable income can also be reduced by any current year capital expenditures that aren’t required to be capitalized for tax purposes under the tangible property regulations.
Once taxable income or loss from rental activities is determined, the LLC allocates an amount to each investor based on the profit and loss allocation provisions in the LLC’s operating agreement. This is due to the fact that a direct real estate investor is able to capture his or her pro-rata share of income or losses. This also stands in stark contrast to REITs and other investments. This allocation may be as simple as multiplying your percentage ownership to taxable income or loss for the LLC. Partnership tax rules allow for flexibility and creativity in how income and loss may be allocated, so it’s important you understand the profit and loss provisions you agreed to when you invested in the LLC.
This section of the Schedule K-1 reports the changes to your capital (or equity) in the LLC, including allocation of net income or loss, capital contributions and distributions received during the year. It is important to make note as to which method capital is being reported. If the Schedule K-1 is reported on a tax basis, this amount is added to the liability allocations to calculate overall tax basis* in your investment. If the tax basis box is not checked, you will need to track your tax capital separately each year.
It is common for LLCs that own rental real estate to leverage the property with debt, no different than you may with a mortgage on your primary residence. While banks lend on a lower loan-to-value on investment real estate compared to primary residences, the interest is deductible against rental income collected. When rental real estate is leveraged it’s common for it to have positive cash flow and generate tax losses for a number of years due to interest and depreciation deductions. The IRC limits the ability to take losses or tax-free distributions to the extent of a partner’s basis in their partnership interest. This is where debt plays an important role by providing an additional basis beyond the cash contributions.
Example 1: In 2015, you invested $50,000 for a 10% limited membership interest in ABC LLC, which bought a commercial building for cash. From 2015-2017, ABC LLC does not pay any distributions and allocates to you rental losses of $50,000. In 2018, you received an allocation of $5,000 of rental income and received $15,000 in cash distributions. Your basis in your ABC LLC interest on 1/1/18 was $0 ($50,000 initial capital contribution less $50,000 of allocated rental losses). Later in the year, your basis increased to $5,000 for the rental income allocated immediately before your cash distribution. Since you received distributions in excess of basis, there will be $10,000 of gain to be recognized on your 2018 individual tax return.
Example 2: Same as Example 1, except that ABC LLC incurs debt of $1,000,000 on the building purchase. Assuming no member has personally guaranteed the debt, your allocable share of the debt is $100,000 ($1,000,000 debt x 10% ownership). Your initial basis is now $150,000 in the ABC LLC membership interest ($50,000 cash contributed + $100,000 debt allocated). On 1/1/18, your basis became $100,000 ($150,000 initial basis less $50,000 of allocated rental losses). When ABC LLC pays you the $15,000 cash distribution, it now reduces basis to $90,000 (Your 1/1/18 basis plus $5,000 rental income less $15,000 cash distribution). There is no taxable gain for distributions in excess of basis for you.
The LLC must report to all investors their share of liabilities on Schedule K-1. The tax rules regarding partnership liabilities are some of the most complex in the IRC, but in most situations, the nonrecourse and qualified nonrecourse (QNR) liabilities are allocated based on the investor’s profit percentage. Recourse liabilities are those the investor has personally guaranteed and will be allocated based on specific facts and circumstances relating to those liabilities.
The allocation of liabilities can be important for investors in rental real estate by providing tax basis to take their allocable share of losses. When an LLC allocates a rental real estate loss to you the investor, you are limited to three different ways from taking the loss against other income.
The first limitation allows losses only to the extent of tax basis in the LLC interest. If there is sufficient basis, the next limitation allows losses to the extent of at-risk tax basis, which you are economically responsible for. You should know – cash invested carries at-risk basis because if the partnership does not repay this capital then you lose your investment. For investments in limited partnerships or LLCs, you generally are only economically responsible for any liabilities allocated if you personally guaranteed these debts. If the partnership failed to pay on the debt the lender may have legal recourse to demand payment from the guarantor, making them economically responsible for this debt allocation. However, it is uncommon for limited partners to guarantee loans of the partnership or LLC.
The rules around at-risk basis have a carve-out for qualified nonrecourse (QNR) liabilities. For the debt to be classified as QNR it must: be secured by real property, the lender is one that is in the business of lending money, no one is personally liable for the debt and it is not convertible debt. QNR allocations to limited partners are considered at-risk basis for the member. This allows losses to be claimed even though they are not economically responsible for repayment, subject to the passive loss rules.
Example 3: Same as Example 2, except that your allocable losses are $75,000 and ABC LLC borrowed $1,000,000 on the building purchase from an individual not in the trade or business of lending money. On 1/1/18 your basis was $75,000 ($150,000 initial basis less $75,000 of allocated rental losses). Of the $75,000 in losses, you may claim $50,000 of the losses against passive income. The remaining $25,000 are suspended under the at-risk limitations. When ABC LLC pays you the $15,000 cash distribution, it reduces basis to $65,000 (your 1/1/18 basis of $75,000 plus $5,000 rental income less $15,000 cash distribution). There is no taxable gain for distributions in excess of basis.
Example 4: Same as Example 3 except the building loan was obtained from a qualifying lender making the liability allocation QNR. The full $75,000 of loss allocations are available to offset other passive income.
The final hurdle to receiving allocations of rental real estate losses are the passive loss rules. Rental real estate losses are considered passive by default** and can only be used to offset passive income from other sources. Any unused passive losses carry forward indefinitely until there is passive income or until that activity is disposed of.
Example 5: Same as Example 3 and you do not have any other passive investments. You have $50,000 of suspended passive losses and $25,000 of suspended at-risk basis losses, both carrying forward into 2019. In 2019, ABC LLC allocates $30,000 of rental real estate income to you. Since you have $75,000 in total suspended losses there will be no rental real estate income reported on Form 1040. The 2019 income allocation first frees up the suspended at-risk basis losses, then frees up suspended passive losses. You will have $45,000 of suspended passive losses and $0 suspended at-risk losses to carry into 2020.
As you can see, the tax implications of investing in an LLC are more complex than investing in the stock market. However, that complexity also provides unique benefits, such as the potential to take tax-free distributions in years the LLC generates a tax loss. Part two will look at additional benefits provided through depreciation deductions and preferential tax rates on the sale of real property.
*Basis represents the amount invested in the LLC which is needed to determine gain or loss upon sale of the LLC interest. This amount is determined annually by increasing basis for capital contributions and income allocations and decreasing basis for distributions and loss allocations. Basis also includes liability allocations.
**In order for rental real estate losses to not be considered passive, you must be considered a materially participating real estate professional (MPREP). To achieve this designation, you must have more than 750 hours in real property trades or businesses during the year, with at least half of your time in those activities. Additionally, you must pass one of the seven tests of material participation in rental activities. An election on your tax return can be made to group all rental activities together in order to meet the material participation tests. The MPREP designation can also provide a benefit if there is rental real estate income reported. For married filing joint (MFJ) taxpayers with over $250,000 of modified adjusted gross income ($200,000 for single filers), passive income is also subject to the net investment income tax. Taxpayers qualifying as MPREPs are not subject to this 3.8% tax on the net rental income, nor the gains when rental properties are sold.