As a passive real estate investor, it’s essential to understand the tax implications and benefits of investing in a private investment fund.
For starters, most private investment funds are typically organized as partnerships in the form of LPs (limited partnerships) or LLCs (limited liability companies).
The investment fund invests the money it pools from investors, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company. Investors are treated as passive partners for tax purposes.
Most investment funds prefer the partnership tax structure over the corporate structure to avoid double taxation and to allow for the fund’s income to be taxed at the investor level and provide for the flow-through treatment of income, expenses, gains, and losses.
Each investor receives a K-1 tax form at the end of the year, reporting the investor’s allocated share of these income, expense, gains, and losses items for inclusion in their tax returns.
The following is the typical lifecycle of an investment fund with the relevant periods – each with its tax implications:
LIFECYCLE OF INVESTMENT FUND
As a general rule, an investment fund’s profits and losses are allocated to investors on a pro-rata basis. However, since most of these funds are organized as partnerships, the fund’s Operating Agreement (LLCs) or Partnership Agreement (LPs) may provide for special allocations of income, expenses, gains, losses, etc. as agreed upon in the partnership agreement.
Taxation of Distributions
As a general rule, profit distributions (including preferred returns) from income that is connected with the fund’s trade or business are taxed as ordinary income. However, this regular income can be offset by the partner’s allocated share of deductions and depreciation.
Also, thanks to the 2017 tax reform, taxpayers who earn less than $157,500, or $315,000 for a married couple, can deduct 20% of the income they receive via pass-through businesses from their overall taxable income.
If a partner receives a distribution from the partnership that is above the partner’s share of the fund’s income as reported on the K-1, these distributions will be considered a return of capital.
While any distributions considered a return of capital is not taxable, the distribution lowers the basis (i.e., original cost) of the partnership interest, which will affect the amount of capital gains realized when the interest is sold or liquidated.
Distributions from the sale or liquidation of a partnership interest will be treated as capital gains – short-term or long-term, depending on the holding period. The amount of recognizable capital gains will be directly impacted by the partner’s basis in the partnership interest (i.e., outside basis, capital account balance).
Tax Basis (Capital Account)
A partner’s original basis in his/her partnership interest begins with the original capital contribution, and then over time, taxable income and additional contributions will increase the basis.
At the same time, depreciation, expenses, and distributions will reduce it. The basis is further enhanced by the partner’s share of partnership liabilities and reduced by repayments of liabilities.
An investor makes an initial capital contribution of $1,000,000 in exchange for a partnership interest; his initial tax basis will be $1,000,000.
The fund has generated $400,000 in annual revenue, $200,000 in operating expenses, and has allocated $100,000 in depreciation over the life of the investment.
Total taxable income amounted to $100,000 ($400,000 – $200,000 – $100,000). The investor’s share of income that income is $50,000 distribution payments totaled $100,000.
The partner’s ending basis in the partnership will equal $950,000 as outlined below:
If the investor receives $1,000,000 for his partnership interest from a sale or liquidation, that will result in capital gains of $50,000 ($1,000,000 – $950,000).
These are the very basic tax implications of investing passively in a private investment fund and should not be taken as tax advice.
If you’re considering investing in a private fund, we recommend you consult your tax advisor for a complete discussion of the tax factors of passive investments.