You are an operator of a new real estate venture with a strategic capital partner. While you are not required to contribute any capital upfront, you look forward to your capital gains windfall when the property sells in five years.
However, when the venture was operating only in the final few months of the year, you are shocked to see an allocation of ordinary income to you on your Schedule K-1. You now have to scramble to pay the tax liability on this income because you have not received any cash distributions from the venture.
Why does taxable income not equal cash received?
In rental real estate partnerships, the net cash flow in a given year will differ from the taxable income for a variety of reasons. In the year of acquisition, many of the initial capital expenditures to create the partnership, purchase the real estate or obtain financing require capitalization for tax purposes. These costs are recoverable through various deductions during the life of the venture. Other considerations include the potential limitation of interest expense, establishment of a capital reserve, or cancellation of debt. Prepaid rent, along with the considerations above, may drive taxable income to be different from expectations.
How was the income allocation determined?
Once taxable income has been determined, the next step is to evaluate the allocation of income among the partners. The partnership agreement drives allocations of income with terms that vary among different ventures. In many scenarios, the income allocation is derived from target capital allocations. Target capital allocations require the partnership to allocate income to the partners based on what each member would receive in the event of a hypothetical liquidation of the partnership’s assets based on their section 704(b) value as of the end of the tax year. Section 704(b) basis reflects the economic substance of the deal. If the hypothetical distribution at the end of the tax year exceeds rates of return dictated in the partnership agreement, an operator may receive a greater allocation of taxable income than expected. In certain situations, a partner may receive more income than cash in a given year. This is often referred to as “phantom income.”
What can you do to reduce phantom income?
In order to avoid a potential allocation of phantom income, the following potential solutions for operators are worth considering:
- Cost segregation or purchase price allocation review
- Comprehensive review of accounting methods
- Analysis and consideration of real estate trade or business election
- Review drafting of partnership agreement and consideration of implications
Throughout the life of a real estate venture, taxable income may vary significantly compared to cash flow on a year-to-year basis. Due to that fluctuation, partners may have to pay taxes on income at different points (and at different tax rates) in the real estate life cycle than expected. By analyzing various considerations upfront, exposure to phantom income can be minimized.