As tax season unfolds, many investors are receiving their Schedule K-1 (Form 1065) documents. These forms play a crucial role in reporting your share of a partnership’s financial activities, including income, deductions, and credits, on your individual tax return.

Given that we’ve recently distributed over 900+ K-1s to our investors, we recognize that for many, especially those new to investing, interpreting this document can seem like a daunting task. To help, we’ve created this guide with the goal of demystifying and explaining the crucial parts of the K-1 form

Disclaimer: We are not tax professionals. This post aims to highlight the K-1 form’s key sections and purposes, serving just as an introductory guide. It should not be considered as financial, tax, or legal advice. For any specific, personalized tax advice, consulting a professional tax advisor is strongly recommended.

What Is the K-1 Form?

The Schedule K-1 form is an essential tax document in the United States, detailing an investor’s share of income, deductions, credits, and other pertinent tax items from investments in partnerships, S corporations, estates, and trusts. For those invested in multifamily projects, typically structured as partnerships or limited liability companies (LLCs) taxed as partnerships, receiving a K-1 is a standard part of the tax filing process.

Breaking Down the K-1

To make our discussion practical and insightful, we will examine the K-1 form using a hypothetical scenario: a $100,000 investment in a multifamily project. This case study will help us explore the K-1’s key aspects, including important elements like depreciation impacts year over year.

Let’s review the various sections of the K-1 document for the current year 2023 which will assume as the second year of this investment.

Part 1: Information About the Partnership

At the top in Red, the K-1 form provides essential details about the partnership which is the entity through which the investment was made, and investors are members of. The key information in this section includes:

  • Partnership’s Name and Address: Essential for identification, ensuring consistency with other tax documents.
  • IRS Center: Indicates where the partnership’s return was filed, which might be relevant for specific inquiries or follow-ups.

Part 2: Information About the Partner

This section highlighted in Blue dives into specifics about the partner’s (Investor’s) involvement and financial standing within the partnership. The key information in this section includes:

  • Type of Partner: Distinguishes between individual, corporation, etc., affecting the tax implications of the partnership income.
  • Share of Profit, Loss, and Capital: Reflects the partner’s financial involvement at the beginning and end of the year, essential for tracking investment performance and tax obligations.

Detailed Breakdown of the sections:

  • Sections E and F: Cover the investor’s Tax ID and address, basic but crucial for tax purposes.
  • Sections G – I2: Clarify the partner’s status (General Partner [GP], Limited Partner [LP], etc.) and the nature of their participation (Domestic, Foreign Partner, Disregarded Entity, Individual, IRA), impacting tax treatment.
  • Section J: Indicates the partner’s profit/loss allocation percentage, dictated by the initial partnership agreement. Typically, this % is unchanged during the hold period barring significant partnership adjustments.
  • Sections K1 – K3: Relate to the partner’s share of non-recourse or recourse liabilities, essential for understanding potential financial liabilities stemming from partnership financing.
  • Section L – Partners Capital Account Analysis: Perhaps one of the most important sections, it traces the evolution of the partner’s capital account over the year, reflecting initial value, any losses (often influenced by depreciation), distributions, and the closing value. This section is vital for tracking the taxable basis of your investment.

In this example the partner has a beginning capital account  of $35,604. For  the year, the partnership recorded a loss of $8,658 (see Part 3 details below). By year-end, the capital account stood at $25,538 after subtracting the loss and distribution from the beginning capital account. These changes are pivotal for investors to understand, as they directly influence tax obligations and reflect the investment’s financial health.

Part 3: Partner’s Share of Current Year Income, Deductions, Credits and Other

The sections in Yellow outline the income, loss, and distributions for the investment. In the current example, $2,716 was the net loss after factoring in depreciation, there were other deductions of $5,942 that may include items like business interest expense amongst other things and there was also $3,408 of distribution. These 3 amounts were factored in to come up with the ending capital account of $25,538 in Part 2 Section L above.

Comparing Year 1 and Year 2 

The transition between Year 1 (Acquisition year) and Year 2 for this investment, as reflected in the Schedule K-1 forms for both years side by side, provides a good understanding of the nuances of investment dynamics, especially the impact of depreciation and distributions on the investor’s capital account over time. Let’s dive into this comparison to understand these dynamics better.

 

Year 1  K-1 Overview

  • Initial Investment: The investor has committed $100,000 to this project in 2022. This amount represents the initial capital contribution, setting the foundation for the investment’s capital account.
  • Depreciation: The investment incurs a significant loss of $64,396, attributed primarily to accelerated depreciation. Accelerated (Bonus) depreciation is a tax incentive that allows for a substantial portion of an asset’s cost to be depreciated in the first year of service, resulting in a notable tax loss for the year.  
  • Distributions: The K-1 for 2022  indicates no distributions were made during Year 1, see  Part II, Section 19 of the form.
  • Capital Account Adjustment: The heavy depreciation expense drives the capital account down to $35,504 by the end of the first year.

Year 2 K-1 Overview

  • Starting Point: The capital account opens the year at $35,504, carrying forward the ending balance from Year 1.
  • Continued Depreciation and Deductions: Year 2 sees additional tax losses totaling $8,658. This figure comprises $2,716 and $5,942 from further depreciation and other deductions, respectively. The reduced magnitude of depreciation suggests that the bulk of the depreciation benefit was front-loaded into Year 1.
  • Distributions: Unlike the previous year, the investor receives distributions amounting to $3,408. These distributions are payouts to the investor, effectively reducing the capital account.
  • Year-End Capital Account: After accounting for the year’s losses and distributions, the capital account diminishes to $23,538.

Moving into next year (Year 3), the capital account starts at $23,538 for this investor. The trajectory from this point will depend on the property’s operational performance, potential for additional deductions, and the possibility of further distributions and/or any capital events if any. The initial years of depreciation have set a foundation that may lead to different tax considerations as those benefits taper off. 

We hope this blog has served as a helpful starting point in your journey to understanding the K-1 document and has empowered you with the knowledge to approach tax season with confidence. 

While we’ve aimed to demystify certain aspects of the K-1, it’s important to acknowledge the value of professional advice. Tax laws and investment nuances are complex and ever-evolving. Therefore, consulting with a tax professional or financial advisor who can provide personalized guidance based on your overall financial picture is highly recommended.