With this tax season underway, you should be expecting or receiving your 2021 K-1s (Form 1065) for your limited partnership interests. Whether you inherited the interest or were the original investor, understanding what your K-1 means is vital to determining whether or not your holding is performing for you. While our team at LP Equity are not financial advisors or accountants, we are well versed in evaluating K-1s from an investment perspective. Let’s walk through a quick example to illustrate how you can evaluate the performance of the investment.
The first step to understanding your K-1 is to determine what your net rental real estate income is. You can find this by looking under ‘Part III’ and Box 2 from the first page of your K-1. This number is used to calculate the income tax the limited partner must pay and is treated as ordinary income. For example, if the figure listed in this box was $12,300, and the limited partner were in the 40% tax bracket (ignoring any other income or tax circumstances) the limited partner would owe $4,920 in Federal Taxes.
Next we want to look at the distributions paid to the partner in the year indicated on the K-1. This can be found under ‘Part III’ and Box 19. To continue with the example from above, if the limited partner received a distribution in the amount of $3,400 this would not be enough to cover the taxes due. In this example, for this year the limited partner would have a net out-of-pocket loss of $1,520 as a result of their ownership of the interest.
In this example scenario, the limited partner has ‘phantom income’ or income that they are paying taxes on but are not actually seeing in the form of distributions. Phantom Income as a tax phenomenon comes about as the result of the cessation of the depreciation of given long-standing tax shelter holdings, which results in a negative balance between the cash being paid out constructively to a limited partner and the taxes owed on the reported income of the holding.
This situation, when it occurs, is obviously undesirable to the limited partner, but the truly difficult feature of these limited partnership interests is that, due to their intricate design and undesirable tax status, they are very difficult to liquidate, which leaves limited partners trapped in a cycle of unending losses that can extend through their heirs and their estates. LP Equity has been working with limited partners for nearly 2 decades to directly assist in the liquidation of such burdensome limited partnership interests. If you believe you or an associate may be beset with a real estate holding that is generating phantom income, please reach out to our team with any questions about how LP Equity can help you create immediate liquid cash on these holdings.