Liability Allocations and Why They Should Matter to You
Ever noticed that section titled “Partner’s share of liabilities at year end” on your Schedule K-1? If you haven’t, cut yourself some slack because it’s easy to miss. These three lines in Section K titled “nonrecourse”, “qualified nonrecourse financing” and “recourse” are unique to partnership K-1s. While they may seem merely informational, they are actually quite important in determining whether or not any losses flowing through on your K-1 are deductible on your individual return. This is particularly relevant to real estate entities, as depreciation deductions often cause these partnerships and LLCs to operate at a tax loss.
So let’s say you are a real estate investor, and you receive a K-1 with a large loss in Box 2, which reports rental real estate income or loss. This is great news for you since you have other items of income, like your wages, interest, and dividends, you are hoping to offset. These should cancel each other out and help to lower your tax liability, right? Not so fast. Just because you were allocated a loss on your Schedule K-1 doesn’t mean you are able to deduct that loss on your individual return. Why not? Because tax law has set up several hoops for you to jump through in order to receive the benefit of those losses in the current year.
Two of those hoops are your tax basis and at-risk basis in the entity, both of which take into account your share of partnership liabilities allocated to you on your K-1. If your share of partnership liabilities shifts significantly from year to year, or if you run out of tax and/or at-risk basis, this could significantly impact the deductibility of the loss on your individual return in the current year.
So what can you, as an investor, do about this? Pay greater attention to this section on your K-1 each year. Does it seem reasonable? If not, ask the LLC member manager about it. Review your operating agreement to see if you have the option to look over the tax return to understand how the liabilities are being allocated. Have a conversation with your CPA to determine how you’ve been affected by this in the past and what you can do to maximize your chances of deducting these losses in the future. And of course, feel free to reach out to one of us if you would like to discuss further.
Delap LLP is one of Portland’s largest local tax, audit, and consulting accounting firms, located in Lake Oswego, Oregon.