Tax Basics Part 1 – Tax Forms Every Real Estate Investor Should Understand (Form 1040, 1065, K-1, Schedule C & E, 8582)

Understanding taxes can be extremely difficult especially since tax rules continue to get increasingly complicated. The good news is that you can always hire an accountant to file your taxes for you. However, it’s not a good idea to rely completely on your accountant when it comes to taxes. It’s best to have an understanding of the basics so that you can weigh the tax complications of going about business activities in one way over another. That being said, we’re starting this blog series on tax basics to equip existing and potential investors with the knowledge to be able to retain more of their income. Throughout this series, we seek to educate on a few different topics including the following:

1.  Tax forms
2. Things to watch out for when filing taxes
3. Tips to reduce taxes

Within each post, the key points to understand and retain will be restated in the conclusion section. This way, you can come back to the posts in this series as need be and quickly pick up the tips that apply to you. More so, the beginning of each section will have a few high-level bullet points to explain the section’s topic quickly. The target audience for these posts is primarily passive real estate investors, but syndicators and other real estate professionals will also be able to glean insights. If you think there is a critical piece of info not mentioned in any of the posts in this series, don’t hesitate to reach out to me (Tedi – the author). Additionally, feel free to reach out with any questions. Let’s jump into this post!

Note – The definitions of the technical terms in any of our posts can be found in the glossary section of our website.

Form 1040 (U.S. Individual Tax Return) & “Real Estate Professional” Status

This is the standard form for individual income tax returns.

• Real estate investors, including those in multifamily syndications, report their personal income, deductions, and credits on this form.
• Income from real estate activities, such as rental income, may flow through to this form from other forms like Schedule C, E, or K-1.

If you don’t invest in any stocks, real estate, or businesses, this is a pretty straightforward form where you report your income and take out any standard deductions to get to your total income. Then, you report how much tax you paid in W-2 withholding or estimated taxes and calculate your total taxes minus any payments. The result will be the amount you owe in taxes or your tax return. 

Things get more complicated when you invest in real estate, stocks, or businesses. The following are two tax forms that are part of Form 1040 and filled out to further calculate your tax return or taxes due. 

Schedule E (Supplemental Income and Loss): 

• Schedule E is a key form for real estate investors who earn rental income or have passive real estate activities through partnerships, S corporations, estates, or trusts. This is the form used to report income or loss from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in REMICs (Real Estate Mortgage Investment Conduits). 
• As you will learn under the Schedule K-1 section, this is where investors who participate in syndications report their income, losses, and depreciation from their investment activities. 
• Page 2 of Schedule E of Form 1040 will show you all of your passive activities from partnerships and corporations in a consolidated form. In other words, this will show you all of your K-1s put together (see the Schedule K-1 section for more details).

Qualifying as a “Real Estate Professional” and the Tax Implications:

According to the IRS, you qualify as a real estate professional for the tax year if you meet both of the following requirements.

• More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
• You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.

By default, rental real estate activities are considered passive, and losses from passive activities are subject to certain limitations. However, if you qualify as a real estate professional, you may be able to deduct your rental real estate losses against your non-passive income. If you qualify as a real estate professional, you can potentially deduct your rental real estate losses against your other income, such as W-2 wages, business income, or investment income. This can result in significant tax savings. Syndicators, brokers, loan officers, and other professionals associated with real estate activities are seen as “Real Estate Professionals” in the eyes of the IRS. The real estate professional status election is checked off (it’s quite literally a matter of checking a box) on your Schedule E. 

It’s important to understand the difference between active and passive income because the tax implications are huge. Stated differently, if you qualify as a “real estate professional,” you can write off active and passive income. Some examples of active income include:

• Wages and salaries from employment.
• Profits from actively running a business.
• Self-employment income.
• Fees earned by professionals (doctors, lawyers, consultants) for services provided.
• Commissions from sales or real estate transactions for active participation.

 On the other hand, if you don’t qualify as a “real estate professional,” then you can only write off passive income such as:

• Rental income from real estate investments (if the taxpayer does not materially participate).
• Royalties from intellectual property (books, patents, trademarks).
• Dividend income from investments in stocks.
• Interest income from loans or bonds.
• Income from limited partnerships or certain types of passive investments.

Schedule C (Profit or Loss from Business):

• Schedule C is a tax form used by sole proprietors and single-member LLCs to report their business income and expenses.
• If an individual is engaged in a real estate business as a sole proprietor (i.e., they own and operate the business themselves), they use Schedule C to report the income and expenses associated with that business.

The difference between Schedule E and C: 

In general, unless you meet the qualifications to be considered a real estate professional, your rental income is passive and should be reported on Schedule E. If you meet the qualifications to be considered a real estate professional, your rental income is not considered to be passive and can be reported onto a Schedule C. 

Typically, rental properties are not reported on Schedule C even when they are short-term rental properties unless the individual is providing substantial services to the guests of those rentals. Substantial services are similar to those found in a hotel such as daily cleaning, daily meals, ride vouchers, etc. Another common exception is when someone is a dealer in real estate and this for example applies to fix and flippers.

Form 1065 (U.S. Return of Partnership Income) & Schedule K-1

• This form is used to report the income, gains, losses, deductions, credits, etc., of a partnership.
• The partnership itself reports its total income and provides forms to the partners.
• In multifamily syndications, the entity that owns the property is often structured as a partnership. Investors pool their funds into this partnership to collectively own and operate the property.
• The partnership itself doesn’t pay taxes. Instead, the income and deductions flow through to the individual partners via the Schedule K-1. In other words, all of the investors receive a K-1.
• A real estate investor can have multiple K-1s if they are invested in multiple syndications.

In order to ensure your Form 1065 is completed properly, a tax preparer will need the regular, year-end financial statements that are used for a business. This includes:

• A profit and loss statement
• A ledger of revenues and expenses
• Any other documents that demonstrate money earned and spent through your partnership

Just as with individuals filing their tax returns, partnerships may have deductible expenses. Evidence that documents the expenses should also be provided so that they can be entered into Form 1065.

Something to note is that filing taxes has gotten increasingly complex since the 2017 Tax Cuts and Jobs Act. This has resulted in increased costs when filing taxes especially when someone has many K-1s (i.e., you invest in many real estate syndications, are a partner in multiple businesses, etc.). This gets niche, but if you for example invest in a real estate fund that invests in 50 different states, then you will get 50 K-1s and that will make for a very costly (multi-thousand dollar) tax return process. This is something to think about when investing in a real estate fund since the tax implications can drop your return significantly.

Form 8582 (Passive Activity Loss Limitations)

• Passive activity losses are subject to limitations and Form 8582 calculates the allowable losses that can be deducted against other income.
• Excess losses can be carried forward to future years and Form 8582 helps calculate and track these carryforwards.
• For example, if you have $50K in allowable losses that passed through from your syndication investment and you can’t use them all, those losses will carry forward to the next year.
• Depending on the scenario, it’s not uncommon for a person who qualifies as a “real estate professional” in the eyes of the IRS to write off close to all of their income and pay nearly $0 in taxes.

For non-real estate professional-status investors, this form is especially important to pay attention to because it shows how many suspended passive losses they are carrying forward. There are three things to remember here to understand the importance of this form:

1. Designated “real estate professionals” are allowed to write off active income in addition to passive income, while non-real estate professionals can only write off passive income.
2.  Syndicators often pass out K-1s to investors that show significant losses due to cost segregation studies allowing them to claim bonus depreciation (learn about cost segregation studies in this post). Those losses can be used to write off income and pay less tax.
3. The losses on Schedule K-1 due to the bonus depreciation mentioned in the  mentioned in addition to losses from other sources are usually larger than the passive income from the syndication. Thus, non RE professionals typically have losses that carry over into future years.

Investors who have invested in multiple syndications may have a ton of losses that are being carried forward into later years. Those carried losses come in handy when needing to offset gains from a sale which can lead to significantly lower taxes.

Another reason why it’s a good idea to track this form (on Excel or something similar) is that if someone switches CPA firms or accountants, that new firm may forget to look at this form and not carry forward the suspended losses. For example, you can have $100K in suspended losses in 2021 and then all of a sudden in 2022 you can have $0 in suspended losses. What happened? The new firm just forgot to look at Form 8582. This scenario can happen in peak tax season when accountants are grinding and forget to look at the carry-forward losses. This same idea holds if you have any capital losses from the sale of stocks or anything similar. Big picture, you should track these because the new firm must manually input these numbers. When using the same firm, this isn’t much of an issue since they can just roll over files to the next year, thus making things easier to track.

Key Takeaways

• Schedule E (a part of form 1040) is a key form for real estate investors who earn rental income or have passive real estate activities through partnerships, S corporations, estates, or trusts. This is the form used to report income or loss from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in REMICs (Real Estate Mortgage Investment Conduits). 
•  It’s important to understand the difference between active and passive income because the tax implications are huge. Stated differently, if you qualify as a “real estate professional,” you can write off active and passive income. 
• If an individual is engaged in a real estate business as a sole proprietor (i.e., they own and operate the business themselves), they use Schedule C to report the income and expenses associated with that business.
• In general, unless you meet the qualifications to be considered a real estate professional, your rental income is passive and should be reported on Schedule E. If you meet the qualifications to be considered a real estate professional, your rental income is not considered to be passive and can be reported onto a Schedule C. 
• In multifamily syndications, the entity that owns the property is often structured as a partnership. Investors pool their funds into this partnership to collectively own and operate the property. The partnership itself doesn’t pay taxes. Instead, the income and deductions flow through to the individual partners via the Schedule K-1. In other words, all of the investors receive a K-1.
•  Passive activity losses are subject to limitations and Form 8582 calculates the allowable losses that can be deducted against other income.
• Investors who have invested in multiple syndications may have a ton of losses that are being carried forward into later years. Those carried losses come in handy when needing to offset gains from a sale which can lead to significantly lower taxes.

Conclusion

It’s important for real estate investors in multifamily syndications to work with tax professionals who are familiar with real estate tax laws and syndication structures to ensure accurate and compliant reporting. More so, understanding the tax basics for real estate is essential for both seasoned investors and those new to real estate investing. The complexities of tax laws and regulations can significantly impact your bottom line, making it crucial to navigate these waters with knowledge and precision. From deductions and credits to the distinctions between active and passive income, every detail plays a role in shaping your tax liability.

If you have any questions regarding the terms and concepts in this post or previous ones, please reach out to either me (tedi.nati@jpacq.com) or someone on our team so we can help explain further. If you’re interested in investing with us at JP Acquisitions, you can contact us via our contact form, by emailing a member of our team, messaging us on LinkedIn, or signing up for our investor portal to set up a meeting.

As always, I hope you enjoyed reading this post as much as I have writing it. Best of luck!