By Dr. James M. Dahle, WCI Founder
One of the big deterrents for white coat investors to invest in private real estate investments, such as private funds and syndications, is that they have to deal with the tax form known as the “K-1” when it comes time to file taxes. K-1 is derived from Schedule K on IRS Form 1065, the Partnership Tax Return form. Investors wonder if the K-1s will arrive on time, or if they will have to file an extension. They wonder if they will be required to file in multiple states. They also wonder how much depreciation they really get, especially in the first year during these “first-year accelerated bonus depreciation” years (2022 is the last year of that, barring a change in the law.) Let's answer some K-1 questions today and, even better, use some of my own personal investments to show you the truth behind this K-1 game.
Will I Have to File Extensions?
The answer to this one is easy. Yes, you will almost surely have to file a tax extension every year that you invest in these private investments. Just plan on it. You might get lucky, but you probably won't. For tax year 2021, we will be getting 22 K-1s. Seventeen of them came by April 15, leaving five that had not arrived. You may be busy the week of April 15, and if you're paying someone else to prepare your taxes, I can assure you that they're busy. An extension is easy to do and worthwhile even if you don't have to do it. Your taxes are still supposed to be paid by April 15, but you can have up to six more months to actually file the paperwork.
More information here:
Will I Have to File in Multiple States?
The answer to this one is also probably yes. It is possible to avoid this, but you have to be very selective in your investments. If you only invest in syndications and funds that invest in a limited number of states, you could avoid filing in multiple states. What states can you invest in and be OK?
#1 Your state
#2 Any other state you already have to file in for whatever reason
#3 Income tax-free states
- Alaska
- Florida
- New Hampshire*
- Nevada
- South Dakota
- Tennessee
- Texas
- Washington*
- Wyoming
*Washington taxes capital gains above and beyond $250,000 a year. New Hampshire taxes investment income for 2022 but won't in 2023.
#4 States that allow a composite return to be filed (and for which the investment actually files a composite return)
- Alabama
- Arizona
- Connecticut
- Delaware
- District of Columbia
- Idaho
- Massachusetts
- Michigan
- Nebraska
- New Hampshire
- New York
- North Dakota
- Oklahoma
- South Carolina
- Tennessee
- Texas
- Utah
- Vermont
- Wisconsin
Note that composite returns generally make you pay taxes at the top tax bracket. If you're not in the top tax bracket for that state, a composite return can actually cost you more money. Only you can decide if that additional cost is worth the savings of the cost and hassle of filing a return in that state.
What states are left that you want to avoid investing in if you are hoping not to file multiple state returns (unless you are already filing there)? It leaves the following states:
- Arkansas
- California
- Colorado
- Georgia
- Hawaii
- Illinois
- Indiana
- Iowa
- Kansas
- Kentucky
- Louisiana
- Maine
- Maryland
- Minnesota
- Mississippi
- Missouri
- Montana
- New Jersey
- New Mexico
- North Carolina
- Ohio
- Oregon
- Pennsylvania
- Rhode Island
- Virginia
- West Virginia
That's a lot of states to avoid. This may be the classic example of letting the tax tail wag the investment dog. Keep in mind that even if you have investments in these states, you may not have to file. With real estate investments, you often have tax losses for many years. No taxable income (or below a certain minimum in that state) = no need to file.
When Do K-1s Actually Show Up?
Partnerships are required to file their returns by March 15. They don't have any K-1 to send you until they prepare their taxes. To be honest, most of them wait until the very end to file, which means they don't even think about sending out K-1s prior to March 15. Those partnerships that are actually “on the ball” send the K-1s out in the last half of March. However, partnerships are allowed to extend their tax return, just like you are. They can extend from March 15 all the way to September 15, which means it's entirely possible you won't get a K-1 until late September and that you will be scrambling to get your extended return in by your deadline of October 15.
The latest K-1s are often from those real estate investments that are a combination of investments from other sponsors. Basically, your partnership is waiting on other partnerships to do their returns before they can even start your partnership return. This is often the case with real estate funds that invest with multiple sponsors, access funds, and investments bought off of crowdfunding platforms. For tax year 2021, this is when my K-1s actually showed up:
Earned Income K-1s
- WCI (2): March 10
- Physician Partnership: April 8
- 2nd Physician Partnership: April 12
- Physician on FIRE: April 14
- Passive Income MD: September 20 (Draft K-1 sent on April 17)
- The Physician Philosopher: March 8
Unearned Income K-1s
- DLP Housing Fund: March 15
- Arixa Secured Income Fund: March 16
- Unnamed Debt Fund: March 21
- 37th Parallel Syndication: March 25
- AlphaFlow: March 30
- MLG Fund IV: March 31
- RealtyMogul Syndication: March 31
- 37th Parallel Fund I: April 5
- Physician office building syndication: April 8
- CityVest DLP Access Fund: April 14
- Origin Income Plus Fund: April 14
- Equity Multiple Syndication: May 25
- Unnamed Equity Fund: June 21
- Alpha Investing Fund: July 3
- Origin Fund III Fund: September 10 (Draft K-1 sent April 7)
Now, these dates do vary by year. Some years, they're later, and other years, they're earlier. I do appreciate the ones that send draft K-1s. Even though I still can't file my taxes until I get the final one, at least I can use it to estimate how much tax I will owe if they get the draft to me before April 15.
More information here:
The Case for Private Real Estate
Taxable Income and Depreciation by Investment
Over the years, we have invested personally with most of the real estate partners that The White Coat Investor has worked with. Before I take you on a tour of my own K-1s, take a look at who we'd recommend.
Featured Real Estate Partners
OK, I thought it might be instructive to go through each of these unearned income K-1s and show what they end up looking like as far as income and depreciation. I know this would have been interesting to me when I was deciding whether to invest with someone. One of the big benefits, at least of the equity investments, is to get income that isn't taxed, at least in that same year. The income is sheltered by depreciation.
DLP Housing Fund
This is an equity investment of just over $250,000 that I made halfway through 2021. It paid me income of $16,687, all of which I reinvested. There were K-1s from Georgia, Indiana, New Jersey, New York, Pennsylvania, and West Virginia included, but there was no taxable income allocated to any of those states. The K-1 looked like this:
That's $16,687 in income—only $551 of it taxable—and no requirement to file in any other state. Hard to complain about that.
Arixa Secured Income Fund
This is a debt investment I made in mid-2018 with $75,000. I've been reinvesting all of the income over the years. It included K-1s for California, New Jersey, and Pennsylvania, but no taxable income was allocated to those states. For 2021, the fund paid us $6,590.
As a debt investment, this is obviously not very tax-efficient, although the income does qualify for the 199A deduction, as you can see in Box 20 code A. The entire return is paid out each year and is fully taxable at ordinary income tax rates. I'm working on moving our debt real estate into tax-protected accounts as much as possible.
Unnamed Debt Fund
This is a $250,000 investment I made in mid-2020 and where I reinvest all the income. I'd love to have this fund as an advertiser on the site, but they don't want to advertise and they don't even want me to tell you who they are! No state K-1s in this one.
Similar deal to the Arixa fund above. Not tax-efficient but it does qualify for the 199A deduction. It's interesting that one fund reports the income as interest and the other as ordinary dividends, but tax-wise, it's really all the same.
37th Parallel Syndication
This is an apartment building syndication in Fort Worth that I bought $100,000 of in early 2018. It pays dividends quarterly. Since it's in Texas, there are no state K-1s. In 2021, it paid me $2,513.
This one is awfully tax-efficient. That's $2,513 of income that I don't have to pay taxes on this year. Plus, there's even more of a loss I could apply elsewhere if I wanted. 37th Parallel seems to be pretty aggressive about maximizing Bonus Depreciation, and it's probably a good place to go for an investment if you need a loss right away to offset passive income.
AlphaFlow
This is a company I've been less than happy with. It's a debt investment of $20,000 made in late 2017, but it decided, after a couple of years, it really didn't want to do what it originally planned to do (picking a diversified mix of debt investment “notes” for you off of the crowdfunding platforms while offering you pretty good liquidity). It started liquidating my investment in drips and drabs. More than two years later, I still don't have all my money back. Or maybe I do. I started the year with $7,109 still in there and ended it with $2,975. While distributions and “passive income” are great, having 26 different distributions in the year, some as little as $8, is annoying to keep track of. It's a lot like when I was exiting Lending Club and Prosper years ago. At least there were no state K-1s.
Looks like the other debt funds (all interest income eligible for the 199A deduction) but with a little capital loss. I suspect there will be more of those next year as all the notes I still own are delinquent at this point. It'll be interesting to see what the overall return is on this one at the end, but whatever it is, it wasn't worth the hassle.
MLG Fund IV
Although I started this equity fund investment at the end of 2020, 90% of the $250,000 I have in it wasn't invested until mid-2021. I had $4,527 in income for 2021. This K-1 ran 45 pages, including K-1s from Arizona, Florida (don't ask me, it's a “K-1 equivalent”), Georgia, Illinois, Iowa, Kentucky, Minnesota, New Mexico, North Carolina, Ohio, Oklahoma, Pennsylvania, Virginia, and Wisconsin. There was a tax loss in all of those states except Iowa, so I'll need to file in Iowa for this one, I believe. I guess the fund sold a property in Iowa or something.
See what I mean about bonus depreciation? A $250,000 investment gave me a $157,000 deduction. Too bad I can't use it any time soon. Like 37th Parallel, this is not a bad place to go for someone who needs a big passive income deduction this year.
RealtyMogul Syndication
This is an apartment building in Indiana that I bought $10,000 of in late 2014. It was sold in mid-2020. However, it paid out some additional money in 2021 and again in 2022, so maybe I get to keep filing in Indiana for that! Obviously, it comes with an Indiana K-1.
This one is a good illustration of the hassle factor with private real estate investments. What does it cost you to pay someone to handle another K-1 and file in another state? At a certain point, smaller investments like $10,000 may not be worth it. This one is also interesting for some other reasons. First, it says I got a distribution of $1,095 in 2021. That's not true if you look at my bank account, at least in 2021. I only got a distribution of $98 in 2021, but I got another $984 in 2022, so I assume that is the rest of that distribution reported for 2021. But the really interesting thing is that despite the fact that I had this money sent to me later, I don't have to pay taxes on it. In fact, I had a taxable loss ($51) given to me for 2021. That's depreciation at work. I think I've only ever had to file in Indiana one year, the year it was sold.
37th Parallel Fund I
I started investing in this equity fund in early 2020, but it still hasn't called all the capital. That hasn't stopped it from paying out income, though. I got $2,513 in distributions in 2021.
Typical equity investment. A few thousand dollars in income, none of which is taxable, and an even larger loss that I don't have enough taxable passive income to use—at least for now. Now you know why lots of people get excited about Real Estate Professional Status where you can actually use those losses against your ordinary income.
Physician Office Building Syndication
This is for our little partnership office building for my practice. It's pretty low-key. We don't even make distributions, because we just use the money it makes to pay down the mortgage. That's a little bit of a problem since we don't have enough depreciation to actually cover its profit. So, partners get taxed on phantom income with this one. But it's not much income. I have the maximum investment, and it's still only about $700 in taxable income.
Most of the return is still tax-sheltered as this investment increased in value by much more than $700 in 2021.
CityVest DLP Access Fund
This is a debt investment of $100,000 made in early 2019. It was supposed to run just three years, but it had an optional one-year extension that it looks like the fund is going to take. No complaints from me. This year, it paid out $10,097. This one is interesting to me, because I later invested directly with DLP in the same fund. Investing directly gives you more frequent distributions, more liquidity, reinvestable distributions, and one less layer of fees. The K-1 also obviously comes a little faster. The downside? A much higher minimum investment ($200,000 vs $25,000). I keep the direct investment in a tax-protected account, so no K-1 there. This one includes K-1s from Georgia, Indiana, New Jersey, New York, Oregon, and Pennsylvania. However, there is no taxable income sourced to any of those states, so there's no need to file any additional tax returns for this fund.
One interesting thing about this K-1 is that I received distributions of $10,097, but I actually have to pay tax on another $102. Perhaps an accountant can better explain why, but my understanding is that some of what this fund earned (and thus has to pass through to the partners as taxable income) has not yet been distributed to me for cash flow purposes of the fund.
Origin Income Plus Fund
This is a fund of mostly equity but has more of an income focus than many of their funds. I purchased $100,000 of it in early 2020, and I have been reinvesting my distributions. It distributed $5,923 to me in 2021. The K-1 is only 33 pages, so it's not quite as big as MLG's, but it includes K-1s from Georgia, Indiana, Missouri, New Jersey, New York, Oregon, Pennsylvania, and West Virginia. No taxable income was sourced to any of those states, so no returns were required.
The fund is not passing through a lot of losses to me to use elsewhere (not that I can really use them anyway), but it is covering almost all of its income with depreciation. It's a lot like the DLP Housing Fund that way but not like the MLG Fund and the 37th Parallel Fund, which passed through huge losses. Not sure if that's because Origin is doing the depreciation differently or just because these are older funds, but I find it interesting.
Origin Fund III
The Origin Fund was a $100,000 investment that called capital from the time of my investment in mid-2017 until the end of 2019 and then started distributing every time it sold a property, beginning in early 2020. At this point, I think it has distributed back the majority of its capital. It does not pay any regular income as it is focused on total return. So far, I haven't paid any significant taxes on anything this fund has ever made, but that will presumably change now that it is rapidly liquidating. It included K-1s for Colorado, Georgia, Illinois, North Carolina, and South Carolina. I think I only have to file in Colorado and Georgia this year because of it, and I already had to file in Colorado anyway.
I received more than $64,000 in distributions but still had a tax loss of over $5,000. Some of those distributions were a return of capital—perhaps about half of them—but that's still pretty attractive from a tax perspective. I will have to pay taxes on $60 of interest, though, as the real estate losses don't offset that income.
Equity Multiple Syndication
Not much on this one. This investment will take a long time to explain. I'll do it eventually when it finally wraps up. At this point, it's just kind of on hold waiting for the deal to be completed to see what the investors get out of it.
Kind of frustrating that it took until May 25 to send me a K-1 with nothing on it. I bet that took a lot of time to prepare.
Unnamed Equity Fund
This is a $250,000 commitment that started calling capital in mid-2021. As of the end of 2021, only about $76,000 had been called.
Not sure why the depreciation deduction for this one was so low compared to some of the other funds. It may be that the money didn't get invested before the end of the year; I don't know. I expect a lot more on next year's K-1, but it doesn't really matter to me much. It was also interesting to see some ordinary business income too. Anyway, the moral of the story is that you shouldn't be surprised if the K-1 from your first year with an investment isn't quite what you expect.
Alpha Investing Fund I K-1
This is a $100,000 investment contributed in early 2020 but invested gradually over the next couple of years. Let's look at the 2021 K-1 first.
Note the big depreciation deduction on line 2. That's pretty big for the second year of an investment, presumably because most of the investments were made in 2021. Also, notice the distributions total on line 19. Seems awesome, right? Invest $100,000 and get paid $19,000. But it's a little deceiving since more than $15,000 of it was the return of capital (plus profit) from a property that was sold early. Now, let's take a look at the K-1 from 2020.
Note that the distributions and the depreciation were much less in 2020. The interest income, however, was significantly more as the money in the fund sat in an interest-bearing note while waiting to be invested.
More information here:
The 3 Things That Matter Most with Private Real Estate
What's with All These Extra K-1s?
Note how many state K-1s I was sent that have no taxable income on them. It's intimidating to get these K-1s that are dozens of pages long, but that doesn't necessarily mean more state tax returns—at least for the first few years of an equity investment. Most debt investments do not require you to file in multiple states either. I find it really interesting to see K-1s being sent out for a few states from almost every partnership. These include New Jersey, New York, Pennsylvania, West Virginia, and Oregon. I don't even think most of these funds actually have investments in those states, but they must be required to send out the K-1s because some of the investors in the fund are residents of those states. For example, the DLP Housing Fund invests in the following states:
Yet the fund only sent out K-1s from six states—including Indiana, New Jersey, and New York—where it doesn't even have any investments!
Same thing with the Origin Income Plus fund:
It is invested in seven states but sent out K-1s for eight states (Georgia, Indiana, Missouri, New Jersey, New York, Oregon, Pennsylvania, and West Virginia), none of which it actually invests in!
Can You Really Live Off Passive Income?
As you can see, there is quite a bit of “passive income” coming in here. The income from the equity investments is lower as a percentage of the investment, but it is far more tax-efficient than the income from the debt investments. You can see that the income, whether taxable or not, starts adding up after a while, especially for the larger investments. Not including the return of capital, there's enough income there to cover over half of our spending. Is that worth all the hassle of dealing with these K-1s and the costs of filing in multiple states? I think it is, but for me, it isn't really worth it for any investment of less than $100,000.
Only you can decide how much hassle it is worth for you.
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What do you think? Do you hate K-1s with a passion? How many do you deal with each year? Of all your first-world problems, is this your most annoying one? Comment below!
With bonus depreciation sunsetting over the next few years until it’s eradicated in 2026, what is the expectation for how the tax efficiency will be effected of these funds?
Depreciation will be spread out over more years. You still get the same depreciation, it just comes slower. So in a 5 year fund, you’ll get less total depreciation, but also have less depreciation recapture. Overall, less tax-efficient I suppose.
Thanks for sharing such detail and commentary. It is very enlightening. I got about halfway through and started thinking this is awfully complex, seems time consuming (due diligence on front end, including investments you pass on), and greatly contrasts the simplicity of your Boglehead approach to equity investing. Have you tried calculating your returns vs time, net of some pro-rata portion of accounting costs? (I have to believe your accountant loves this?) I was going to ask about risk adjusted return, but is that possible? Is there a Sharpe ratio for this? That said, thanks for being so transparent.
Always a good idea to include the value of your time when calculating your returns. It’s a little different for me though. Keep in mind I’m double dipping on the time because I also get content out of it for WCI.
You get a Sharpe ratio by subtracting the return from the risk free return (usually treasuries) and then dividing by standard deviation of the excess return. Not sure I’m enough of a statistical genius to calculate that for these sorts of individual investments and I haven’t seen anyone else do it. I’m sure it would be quite high for the debt investments though. High returns and not much variation. Lower probably for the equity investments due to much higher variation.
Agree, I always get a laugh comparing the recommended simplicity of investing in index funds versus dealing with delayed tax filing, filing in multiples states, over a dozen K1’s , increased tax prep fees, etc., to be involved in these real estate deals. To each his own, but it sure is comical.
I guess the question is how much hassle are you willing to deal with to have higher after-tax, after-fee returns (or equally high returns but low correlation to your stocks.) For me, I’m willing to deal with some, but not an infinite amount. The key in my case is investing more with each investment. At $10K per investment, it’s a huge hassle. At $1 million per investment, it seems well worth doing. But only a given person can decide if it’s worth it to them at $20K, $50K, $100K, $250K whatever.
I’m just trying to be transparent and show readers what it is really like so they can make an informed decision.
Can anyone summarize any issues related to multiple investments giving K-1s for a state? Is there additional complexity if one but not all of them files a composite return on your behalf?
The summary is that if you invest in private equity real estate funds, you are highly likely to have to file in multiple states. It is possible I suppose to avoid it by carefully selecting funds (or more likely individual syndications in your state and tax free states), but that’s kind of letting the tax tail wag the investment dog. You won’t have to file in as many states as you think, but it’ll still be a bunch. I think we filed in 9 states for 2020 and 12 for 2021.
That part is obvious (maybe not initially but hopefully before investing in these funds). Let’s say you have funds A and B both producing taxable income in the same state you’re required to file in. Fund A offers a composite return and B does not. Would you opt in or out of the composite return for A?
If I were in the top bracket (which I am) I would opt in. If I were not in the top bracket, I would compare the difference in taxes (composite returns always pay at the top rate) with the cost of filing.
Does your accountant charge you extra for these K-1’s?
If yes, how much?
We pay the accountant by the tax form completed, not by the K-1 that we give them, but yea, when we have to file in a new state that’s a whole bunch of new tax forms. We spent $7K on personal tax preparation for 2021. It was closer to $5K in 2020 (12 states vs 9) so that gives you some idea of that additional cost.
Great post, thank you. I just started dipping my toes in real estate syndications in the past year for some diversity, but the multiple state tax implications has been a worry, this is very helpful. Still able to file our taxes myself, so not looking to make it super complicated. Cherry picking investments in states that do not require reporting for K-1s for now, only regret is that limits or knocks out the grouped investment funds I would otherwise like due to the diversity in those funds.
Preaching to the choir man.
Excellent post. So very helpful. Thank you Jim! Have you ever tried filing K1s in a state or two by yourself? Looks like I might have to do that this year, for the first time, and I’m wondering how easy/hard it will be if I do it myself vs. having my tax guy do it. The hassle factor is why I’m mostly investing in passive real estate companies that have a REIT structure and just provide a 1099 (Fundrise, Crowdstreet). But my guess is that I’m missing out on a bunch of the depreciation because of this choice.
Yes. Most tax software can handle it, although I find the state software is much worse than the federal software. Give it a try and see how it goes.
**DON’T GET MAD AT ME! As I should already “know” this.**
I am invested in a dozen or so Real Estate funds and syndications. If I received a 1099 from one of these, is it safe to say that that fund does not send a K1 and therefore that deal wont have the depreciation benefit passed on to me?
Usually yes, but I did have one that would send a 1099 for interest income on uninvested money and then the usual K-1.
REITs tend to pass on depreciation as “return of principal” distributions so you still kind of get it.
What is the taxable passive income, and how we can offset it by bonus depreciation from 37th parallel funds.
Not sure exactly what you’re asking, but the only K-1 I’ve gotten this year from 37th Parallel is for a syndication. I think it showed a taxable loss of about 5% of the investment. Basically, the depreciation more than covered the income.
In reading your excellent article it seems like you do not file in states that you only receive a negative income (depreciation)? Would you not want to file in those states as well so in later years you could use that depreciation to offset against positive income that you might receive? Please correct me, but that is what you would do with federal taxes, yes.
I found this incredibly difficult to sort out. When you multiply 20+ K-1s by 10-15 states, it’s really tricky. It’s the issue that drove me to finally outsource the preparation of my personal returns. For 2021, we filed in 12 states. We’ll file for 2022 in October.
We have not been filing in states where no taxes are due for that year just to document depreciation losses. First because the tax prep probably costs more than the loss would be worth but second because I think one can go back and look at the old K-1s at the time of sale and still get the benefit. Don’t quote me on that one though; there’s a reason I hired a pro here.
Jim, do you remember if the Cityvest DLP access fund qualifies for the 199a deduction? I thought it did not but this year my turbotax is showing it as eligible.
Cool! The underlying fund is a REIT I belief so that’s great that it now qualifies. I don’t think it did for all of the years I owned it.
Thank you for the examples. It helps to know how things work in reality. I’m curious to know how a turnkey property such as from Southern Impressions would compare to some of the equity funds you have above with respect to providing depreciation.
I get a K-1 as a part-owner of our office building which kills me in the tax area when it shows a hefty rental income each year. Some of that is distributed (partially to cover the taxes) but most is more phantom money that pays the mortgage or pays off a retired partner we are buying out. It seems like depreciation from equity funds would be a good way to address this. It sounds like sometimes it is heavy the first year so would you recommend adding funds each year as I am able?
Gracias
Depreciation can vary. More details here:
https://www.whitecoatinvestor.com/depreciation/
https://www.whitecoatinvestor.com/depreciation-my-favorite-tax-break/
But yea, if you want ongoing depreciation, you have to keep buying. You can also opt to spread it out as long as possible.