Equity Based Services, Inc

by Troy Downing

I’ve been getting a few questions about how to interpret the numbers on a Schedule K-1 lately. Obviously, this is a question for a tax professional, which I am not, but, I will try to answer the basic questions of what numbers are represented on our K-1s and how to interpret them.

First off, I want to reiterate what our business is. We invest in tax sheltered, cash flow Real Estate (specifically Self Storage). “Tax sheltered” is an important concept in this type of an investment. It doesn’t mean tax free and it doesn’t mean tax evade. What it means is that the income and returns that are generated have demonstrable tax benefits and means for deferring the payment of taxes.

In other words, the cash flow from the project is sheltered. Part of this sheltered cash flow is taken as depreciation. Depreciation decreases your tax basis in a project and is recaptured as capital gains taxes upon the sale of the asset… Most investors defer the capital gains tax consequences by exchanging the proceeds into a like kind project (”like kind” being a very loose interpretation of what the new investment can be.)

Let’s put this into a hypothetical situation. Let’s use very round and exaggerated numbers to get the point across. First of all, let’s assume that we purchase a cash flow Self Storage real estate project for $1 Million. We finance 50% of it, so, our down payment is $500k. Let’s also assume that this project produces $80,000 per year as gross income.

Normally, one would assume that there was ordinary income, or passive investment income of $80,000. But, there are some things that reduce that. First off, there are expenses. Let’s say that 30% of the gross income is spent on insurance, utilities, taxes, etc. So now, our net income is $56,000. Well, let’s not forget debt service… After all, the bank expects us to pay the mortgage. So, let’s assume a 7% Interest-only loan… This will reduce the net income to $21,000.

So, to summarize, we bought a facility for $1 Million, financed $500k, generated gross income in year one of $80,000 and paid $59,000 in expenses for a final net cash flow of $21,000.

So, the $21,000 is what we receive, so, that’s what we pay taxes on right? Well, not exactly… If you depreciate your property, you can reduce the taxable portion of this income. So, let’s assume, for round numbers, that our project depreciates over a 25 year period. In other words, we reduce the value of the project evenly over 25 years and count it as a loss. So, on our $1 Million investment let’s assume that the value of the improvements (structures) are $475k. If we divide $475k by 25 years, we get $19k in depreciation per year. So, we received $21k in Net Income, but, we only pay taxes on $2k of that. In other words, approximately 90% of our income was sheltered.

The obvious question is, “why is this possible?” We all know that the Tax Man wants his money. So, why does he allow depreciation? The answer is simple- we have not completely rid ourselves of our tax liability, we simply deferred it. Eventually, Uncle Sam will get his share. In this case, he gets it in the form of recapture.

As we depreciate our property over time, we reduce our tax basis in the project. In other words, the base point at which we entered the deal, in this case $500k, is reduced by $19k per year. So, if we held onto this project for 25 years, we would have a near zero cost basis.

The reason that this matters is because our capital gains taxes are based on the difference between the selling price and our tax basis. So, rather than being taxed on the amount you paid for the project, you pay capital gains taxes on the depreciated basis. Currently, capital gains taxes are at 15% federal, so in the grand scheme of things, this is a relatively low tax (please lobby the current administration not to raise these) .

But, there is still a way to avoid, or defer these gains… The IRS 1031 Like Kind Exchange. The IRS allows you, within certain guidelines, to exchange your proceeds into another investment. As long as you do this correctly, the tax liability that was created from the sale of the depreciated project can be applied completely to the new project. Currently, the tax code allows you to do this ad infinitum. Many investors strategize to defer the taxes on these projects beyond their lifetimes. Of course, you may also choose to take part of the return, pay taxes on that portion, and exchange the rest. There is some flexibility with this, and the proceeds may go into more than one project.

So, all of this information about depreciation and recapture is simply exposition to answer the most common question I get on Schedule K-1s…. “Why did my capital account go down?”

The IRS Schedule K-1 is a tax document that reports a partner’s share of Income, loss and Deductions from a business. In general, it will report the percentage of ownership a partner has in a project, what percentage of profit, loss, and capital they own, and their share of any debt that the partnership has on its books.

The interesting parts on the K-1 for answering these questions are as follows.

Section L- Partner’s Capital Account Analysis
This section lists the partner’s capital account value at the beginning, any capital added during the year, and any increase or decrease in that account with an ending value at the end. To put it simply, the beginning amount is the capital contributed to the partnership. So, this is the partner’s starting basis. The basis is reduced by depreciating the property over the year. So, if there were no contributions during the year, and depreciation was taken, the basis will go down over time. This does not mean that the partner’s ownership in the project has gone down, or that the value of the project has gone down. It simply means that the basis has been reduced. This will also have a line item for distributions. Distributions are cash returned to the investor and are not necessarily income. Just as taking money out of your bank account is not income, but the interest it generates is.

Even if the project produced positive cash flow, the depreciation will reduce this.

In Part III there are usually 3 sections that have numbers of interest. First off, line 1 shows the amount of ordinary business income or loss. This will be the net from normal operations of the business with the exception of rental income. So, this will generally be retail sales and services. Line 2 is the Net income or loss from rental real estate income, and line 5 is any interest that the project generated, usually in interest bearing reserve bank accounts.

In lease-up deals, the cash flow generally starts out very low and increases as the project is stabilized. The real value in the project comes from the increased value of the real estate upon stabilization. Because of this, the net income numbers will start out very low or negative. This is expected and is normal.

On stabilized projects, especially newer acquisitions, you will often see the “Distributions” line in section L much higher than the net income numbers in Part III. This is due to the fact that the distributions are not directly indicative of the net profit/loss of the business. These have been reduced for all of the reasons that were mentioned above.

So, the most common question I get asked from a new investor trying to decipher a K-1… “My K1 only showed $1,000 in income last year, but, you sent me $10,000 in distribution checks. Is this a mistake?”. My answer, of course, “No. It’s not a mistake. You are just seeing 90% of your cash flow tax sheltered because you invested in a tax sheltered, cash flow real estate project.”

The second most common question: “I see that my capital account was reduced. Does that mean that the project isn’t performing?” Again, “no, this is normal and expected. This is a result of deprecation and tax sheltering. It allows you to keep more of the cash flow dollars in your pocket.”

Finally, my disclaimer- I am not a tax professional, I am a Real Estate Professional. These are not complete and should be verified with a tax professional to understand the nuances and to verify this information. I believe the statements to be true and correct, but, not necessarily complete as it is not my area of expertise.

If you are an EBS investor and have questions about this, please call and set up a meeting or call with our in-house CPA.