Tax time: Pros and cons of fund 1099-DIV and K-1s
Tax time: Pros and cons of fund 1099-DIV and K-1s
Investing in a new-to-you asset class can be a great way to diversify your portfolio and gain passive income. But there is always a learning curve with new types of investments—and that often includes learning about a new set of IRS acronyms. When investing in commercial real estate, you’ll want to get familiar with the two main forms that most funds use to report at tax time—and why: K-1s and 1099-DIVs.
What is a K-1?
A K-1 is a form used to report earnings, losses, deductions, and credits from certain types of business entities, such as partnerships and S-corporations. Funds or partnerships using K-1s are pass-through entities, meaning the nature of their earnings and income—and their associated tax liability—is passed through directly to partners. If you’ve invested in a fund like this, you typically don’t need to actually file the K-1 with your taxes, but you’ll need the information on the form to calculate your total tax liability. And in the case of a commercial real estate fund, if the fund includes properties in multiple states, there’s a possibility of having income to report in multiple states, depending on the way the fund is structured.
If you know anything about K-1s in commercial real estate, you may have heard that they’re notorious for arriving late. This can turn some investors away from investing in funds that report this way. But at DLP Capital, we are proud to say we have always sent K-1s to investors on time. Two of our funds, the DLP Housing Fund and the DLP Building Communities Fund, report using (timely) K-1s.
What is a 1099-DIV?
A 1099-DIV form is likely more familiar to investors—the same form that banks and other financial institutions use to report income you’ve earned from interest or dividends. The financial institution or investment company sends you a copy and also provides one directly to the IRS. As with a K-1, you’ll use the information on this form to calculate your total tax liability.
Many investors find these forms easier to deal with than K-1s. Because these forms are so commonly used, most tax software makes it easy to incorporate income from a 1099-DIV into your tax return. Our DLP Preferred Credit Fund and DLP Lending Fund report using 1099-DIVs.
Funds are required to use one tax reporting form or the other based on the tax entity classification and structure of the fund, so different types of funds will come with different reporting forms. Our DLP Housing Fund and DLP Building Communities Fund are structured as partnerships, therefore K-1s are issued to investors. Our DLP Preferred Credit Fund and DLP Lending Fund are structured as REITs (a type of corporation) and issue 1099-DIVs to investors. Investors can seek out the type of fund that works best for them—or results in their preferred type of tax reporting form—with the help of a tax professional.
Tax Advantages of the DLP Housing Fund
The DLP Housing Fund is our most tax-advantaged fund. This fund includes a “REIT Blocker” entity that sits below the fund where all of the rental activity and depreciation is reported. The REIT files returns in all the states it operates in and only passes through dividend income to the larger fund, which in turn issues K-1s to investors, simplifying tax reporting for investors. This structure allows investors to avoid the hassle of reporting income in multiple states. For many investors, income from this fund also counts as qualified business income, 20% of which can be deducted on your taxes. As with everything tax-related, the definition of “qualified business income” gets pretty technical, but essentially, it allows individuals, trusts, and estates a 20% deduction for the net amount of qualified income and loss with respect to any qualified trade or business. Qualified REIT dividends, which is the type of income passed to investors from the DLP Housing Fund, is considered qualified business income but, more importantly, does not have the same income limitations with respect to the 20% deduction as an investment with no REIT.
Additionally, because the fund is structured as a partnership, many investors will be able to take out what are called return of capital distributions, which aren’t taxable—essentially, taking some of your original investment out of the fund before you have any taxable gains.
Tax structure of the DLP Building Communities Fund
Income from our DLP Building Communities Fund consists of rental real estate, interest income, and dividends. This fund has a unique structure where eligible investments are held in our “REIT Blocker” and all others flow directly to the fund. Similar to the DLP Housing Fund, this fund may also generate qualified REIT dividends through its REIT Blocker but also generates qualified business income through its rental real estate activities, both eligible for the 20% deduction. As this fund’s projects develop and move into a stable operating mode, there is a potential for investors to take some depreciation benefits as well. DLP Capital is constantly evaluating which investments should be held in our REIT Blocker to maximize the tax benefits to investors.
There are many different ways to invest in commercial real estate and reap the benefits of passive income. Talk to your tax professional about the pros and cons of different types of forms and fund structures to figure out what works best for you. If you have questions about any of our funds, contact our Investor Success Team at email@example.com or phone 610-488-2375.