Investing in real estate funds and syndications offers access to institutional-grade assets but often involves complex tax considerations.
Investing in real estate funds and syndications can provide access to institutional-grade assets, but it also can introduce special tax considerations. This FAQ is designed to help investors understand:
- Typical tax reporting practices
- Expected documentation
- Why tax outcomes may differ from cash flow
Please note that the following answers reflect common practices but may vary depending on fund structure and individual circumstances.
Always consult your fund’s Private Placement Memorandum (PPM), Limited Partnership Agreement (LPA), or Operating Agreement, and seek advice from a qualified tax professional.
Before you invest
What documents explain how taxes work in the fund?
The PPM, LPA, and subscription documents detail how profits, losses, and distributions are allocated, when Schedule K-1s are issued, and any applicable tax elections (i.e. Section 754 or Section 1031 exchanges).
Will I get a tax summary before I invest?
Many fund sponsors and syndicators will provide a sample Schedule K-1 or tax overview to illustrate typical income and allocation flows.
What is a preferred return, and how is it taxed?
A preferred return is a priority allocation of income, typically taxed according to its character, such as rental income or capital gains. Specific terms are outlined in the fund’s organizational documents.
During the life of the fund
How are profits and losses allocated?
Allocations follow the partnership agreement, often granting limited partners priority up to a preferred return, before profits are shared with the general partners. Refer to the LPA for the specific waterfall structure.
Can I deduct my share of tax losses?
Generally, yes, subject to passive activity loss rules, at-risk limitations, and your tax basis. These types of losses typically offset other passive income.
What happens to suspended passive losses?
Suspended losses remain until they are offset by passive income or upon sale of the property or fund interest.
Are distributions taxable?
Distributions from operations or refinancing are usually not immediately taxable and reduce your basis. However, taxable income may still be reported on your Schedule K-1 even if no cash was distributed.
Why did I receive a cash distribution but still owe tax?
Taxable income and cash flow may not align. For example, the fund may retain cash for reserves while still allocating taxable income.
Will I get distributions from mortgage refinancing? Are they taxable?
Yes, you may receive distributions from a mortgage refinancing if the partnership chooses to distribute part of the loan proceeds. These distributions are generally not taxable immediately because they are treated as a return of capital. However, they reduce your basis in the partnership. If the distribution exceeds your basis, the excess is taxable as a capital gain.
The deductibility of interest in refinancing debt is generally handled at the entity level, but if the debt is traced to distributions used for personal investments or other uses, it may affect your individual interest deduction.
At tax time
When will I get my Schedule K-1?
Most funds aim to distribute Schedule K-1s by March or early April, depending on when final data is received from property managers and accountants. However, timing can also be influenced by the partnership’s filing strategy.
Under the Bipartisan Budget Act rules, partnerships generally cannot amend a previously filed return. Instead, they must file an Administrative Adjustment Request, a more complex and less flexible process.
To avoid this, partnerships may choose to file an extension, even if they’re ready to file. This allows more time to review the return and issue a superseding Schedule K-1 (a corrected version filed before the extended due date), without triggering the AAR process.
While this may delay your Schedule K-1 slightly, it helps enable greater accuracy and reduces the risk of needing corrections later.
Will I receive multiple Schedule K-1s?
Yes, if you invest in multiple funds or if the fund holds interests in tiered partnerships.
Will I have to file in multiple states?
Often yes, if the fund owns properties in different states. Some funds may file composite or withholding returns on your behalf. Be sure to check the PPM for details.
Are Schedules K-2 and K-3 required for my investment?
Possibly. If the fund has foreign income, foreign partners, or international tax items, it may need to file Schedules K-2 and K-3. Even U.S.-based investors might receive a K-3 for compliance reasons. Don’t assume you’re exempt just because the fund operates domestically.
These forms require detailed reporting and coordination across tax and fund teams, even when no foreign activity is obvious.
To avoid delays, funds often collect data early and ask investors upfront if they’ll need a K-3. If you think you will, let your fund sponsor know as soon as possible.
At exit
What happens when a property sells?
You will typically receive allocations of capital gains and depreciation recapture, both reported on your Schedule K-1.
Will I qualify for long-term capital gains?
Yes, if the asset was held for more than one year. Otherwise, short-term capital gains may apply.
What about depreciation recapture?
When a property is sold, part of the gain may be taxed as ordinary income instead of capital gain. This happens because depreciation taken during ownership reduced taxable income. When the property is sold, some of that benefit may need to be “recaptured” and taxed at higher rates.
For real estate, the portion of gain related to depreciation is often taxed at a special rate of up to 25%, even if the rest of the gain qualifies for long-term capital gains treatment. Depreciation recapture only applies when there is a gain on the sale, not a loss.
What if the fund does a Section 1031 exchange?
Gains may be deferred, but participation depends on the funds structure. Limited partners may not always have the option to opt out.
Special investor questions
I am a non-U.S. investor. How does tax withholding work?
Funds typically withhold tax on effectively connected income. You will likely need an ITIN and should consult your tax advisor or fund team for guidance.
Are there UBTI concerns if I invest through an IRA?
Possibly, especially if the fund uses leverage. UBTI rules are complex. It is recommended that you consult your tax advisor.
Capital accounts and basis
How are capital accounts generally maintained?
Capital accounts are updated annually based on each partner’s share of income, losses, and distributions, following the fund’s partnership agreement. While not always shown in detail on Schedule K-1s, accurate maintenance is essential for tracking bases and understanding future tax outcomes.
How do distributions and losses affect my basis?
Distributions reduce basis; income and debt allocations generally increase it. Suspended losses are limited by your basis and at-risk amount.
Why is my capital account different from my original investment?
Capital accounts change annually based on income, losses, and distributions. They may not match your initial cash investment.
Important reminder and disclaimer
These FAQs reflect general practices in real estate funds and syndications. They do not constitute tax, legal, or investment advice.
Always consult your fund’s governing documents and a qualified tax advisor for guidance tailored to your situation.