Owning rentals in a partnership: Form 1065 and K-1 basics

By Tom, CPA · Updated October 27, 2026

Part of: Rental Property Taxes

TL;DR: A multi-member LLC or partnership that owns rentals files Form 1065 (with Form 8825 for the rental activity) and sends each owner a K-1. The partnership pays no income tax; profits, losses and depreciation flow to the partners, who can only use losses to the extent of basis, at-risk amount and the passive loss rules.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

Your tenant pays the mortgage; the IRS pays for the roof, eventually, over 27.5 years. Add a business partner, a sibling or three college friends to the deed, and the IRS also wants a separate tax return explaining who gets which slice of that roof.

That is what a rental partnership is: a pass-through that files a return, pays no federal income tax itself, and hands each owner a Schedule K-1. Most investors meet one when they form a multi-member LLC to buy a duplex with a friend. By default, the IRS treats an LLC with two or more members as a partnership unless it elects to be taxed as a corporation (Treas. Reg. 301.7701-3).

This guide covers the basics: why people use partnerships, how capital accounts and allocations work, what lands on your K-1, and where exits go sideways. It is educational, not a substitute for reading your actual operating agreement with someone who does this for a living.

CPA Warning Label: A partnership agreement copied from the internet can allocate losses the IRS will ignore. Allocations need substantial economic effect, and that lives in the fine print.

Why a partnership

Partnership taxation (Subchapter K, IRC sections 701-777) is the most flexible pass-through regime in the code. That flexibility is the point and the problem.

• One level of tax. Under section 701, the partnership itself is not subject to income tax. Income and deductions flow to the partners, who report them on their own returns.
• Flexible splits. Partners can agree to divide profits, losses and depreciation in ways other than straight ownership percentage, as long as the allocations have substantial economic effect under section 704(b).
• Debt creates basis. Under section 752, a partner's share of partnership liabilities increases outside basis. That is why leveraged rentals can pass through depreciation losses larger than the cash a partner actually invested. An S corporation shareholder generally gets no basis from the entity's bank loans, which is one reason many real estate advisors steer rentals away from S corporations.
• Tax-free-ish contributions and distributions. Section 721 lets you contribute property to a partnership generally without recognizing gain, and section 731 lets the partnership distribute cash without gain until distributions exceed your basis.

The cost: a separate federal return (Form 1065), often state partnership returns, K-1s for every owner, and an agreement that should say a lot more than "we split it 50/50 and stay friends." The return for a calendar-year partnership is due March 15, with an automatic six-month extension available using Form 7004, and the IRS charges a monthly per-partner penalty for late filing (see the Form 1065 instructions for the current amount).

What a partnership does not do: it does not shield income from tax, convert rental losses into non-passive losses, or create a deduction for anything you could not deduct as a sole owner. The LLC wrapper changes liability protection and paperwork, not the economics of the rental.

Capital accounts

Every partner has two scorecards, and confusing them is a rite of passage.

• Capital account (book). Tracks each partner's equity under the agreement: contributions in, share of income in, share of losses out, distributions out. When the partnership liquidates, a properly drafted agreement pays out cash according to positive capital account balances. That is what gives allocations "economic effect."
• Outside basis (tax). Your tax basis in the partnership interest: cash and the adjusted basis of property you contributed, plus your share of liabilities, plus income, minus losses and distributions (section 705 and section 752). Outside basis is what limits your deductible losses (section 704(d)) and measures your gain when you sell.

Since tax year 2020, Form 1065 requires partner capital accounts on the K-1 to be reported on the tax basis method (see the Form 1065 instructions for Schedule K-1, item L). So item L on your K-1 shows your tax capital, which is close to, but not the same as, your outside basis. The big difference is usually debt: your share of the mortgage is in your outside basis, but not in your capital account.

Contributed property is not cash

If one partner contributes a building they already own and another contributes cash, section 704(c) requires that the built-in gain or loss on the contributed property be allocated back to the contributing partner. In plain English: if you contribute a house with a $100,000 basis and a $300,000 value, the $200,000 of built-in gain is yours, not your partner's, when it is eventually taxed. Depreciation also gets allocated to account for the difference between book and tax value, using one of the methods in Treas. Reg. 1.704-3 (traditional, traditional with curative allocations, or remedial). The method you choose changes who gets the depreciation, so it belongs in the agreement, not in a shrug.

Allocations

Allocations are how the partnership divides each item of income, gain, loss and deduction. The default is the partners' interests in the partnership. You can override that with special allocations, but the regulations under section 704(b) only respect them if they have substantial economic effect. The test, in rough terms:

• Economic effect: capital accounts are maintained under the regulations, liquidating distributions follow positive capital accounts, and a partner with a deficit capital account must restore it (or the agreement has a qualified income offset).
• Substantiality: the allocation must have a real chance of affecting the partners' dollars, independent of tax consequences. Shifting losses to the high-bracket partner and income to the low-bracket partner with no change in the actual payout is the textbook failure.

Nonrecourse deductions

Most rental mortgages are nonrecourse or treated as such for these rules. Deductions funded by nonrecourse debt (largely depreciation once equity is used up) cannot have economic effect in the normal sense, so Treas. Reg. 1.704-2 has a separate safe harbor: they must be allocated consistently with some other significant item and the agreement needs a "minimum gain chargeback." If your agreement lacks those phrases, ask why.

Common real-estate splits

Plenty of small partnerships just allocate everything by ownership percentage, which is easy to defend. Syndications and operator-investor deals often use a preferred return and a promote (the operator gets a bigger share of profits above a hurdle). Those waterfalls are allocated through targeted capital account provisions. Fine, but the accounting is complicated enough that DIY spreadsheets tend to drift from what the K-1s should say.

K-1 lines for rental

Rental activity in a partnership is reported on Form 8825 (Rental Real Estate Income and Expenses of a Partnership or an S Corporation), and the net result flows to Schedule K and then to each partner's K-1. The boxes that matter most for landlords:

The three gates for a loss

A Box 2 loss has to clear three gates, in order, before it reduces your tax:

1. Basis (section 704(d)): the loss cannot exceed your outside basis. Suspended losses carry forward.
2. At-risk (section 465, Form 6198): for real estate, qualified nonrecourse financing from a commercial lender generally counts as at-risk.
3. Passive activity (section 469, Form 8582): rental losses are passive unless you qualify as a real estate professional and materially participate. If you actively participate, you may use up to $25,000 against other income, phased out between $100,000 and $150,000 of modified AGI.

Then, separately, the excess business loss limit (section 461(l)) can cap very large non-passive losses. See passive activity loss rules and the grouping election.

Illustration: Fran and Larry form a 50/50 LLC to buy a fourplex for $800,000 (land $160,000, building $640,000) with $200,000 of cash ($100,000 each) and a $600,000 bank loan. Assumptions: allocations by percentage, year-one rent $60,000, operating costs and interest $45,000, depreciation of $640,000 over 27.5 years is about $23,273 for a full year (ignoring the mid-month convention to keep it simple). Net rental result: $60,000 minus $45,000 minus $23,273 equals a loss of $8,273. Each partner's K-1 Box 2 shows a loss of $4,136.50. Each partner's outside basis started at $100,000 cash plus a $300,000 share of the loan, so basis is not a constraint. The loan is commercial and secured by the building, so it is qualified nonrecourse financing and at-risk is fine. Fran's modified AGI is $95,000 and she actively participates, so she can deduct her $4,136.50 under the $25,000 allowance. Larry's modified AGI is $210,000, so his allowance is fully phased out and his loss is suspended until he has passive income or sells. Same building, same K-1 box, different results.

Exit issues

Partnerships are easy to enter and surprisingly hard to leave cleanly. The main traps:

• Selling your interest. Gain is generally capital under section 741, but section 751 carves out "hot assets." For rentals, the big hot-asset risk is section 1245 recapture on personal property, which is common after a cost segregation study. Your unrecaptured section 1250 gain on the building is taxed at up to 25%, and the 3.8% NIIT may apply.
• Debt relief is cash. Under section 752(d), when you sell or are bought out, your share of partnership debt that goes away counts as amount realized. Partners who took depreciation losses for years can owe tax on a sale that produces little or no cash. This is the famous "negative capital account" surprise.
• Distributions in excess of basis. A cash distribution that exceeds your outside basis is gain under section 731. A refinance that distributes cash is usually fine because the new debt increased basis, but run the numbers before the wire.
• No individual 1031 out of a partnership. Partnership interests are not like-kind real property (section 1031(a)(2)). If one partner wants to exchange and the others want cash, the usual workarounds (a "drop and swap" into tenancy-in-common interests) have their own audit history. Plan years ahead, not at closing.
• Section 754 election. When a partner sells or dies, the buyer or heir can get an inside basis adjustment under section 743(b) only if the partnership has a section 754 election in place (or makes one for that year). Without it, the new owner may inherit the old owner's low depreciation base.
• Death. An heir gets a stepped-up outside basis under section 1014, but without a section 754 election the partnership's depreciation does not reset for them.

Spouses and community property

Married couples who own a rental LLC together in a community property state may be able to treat it as a disregarded entity under Rev. Proc. 2002-69 and skip Form 1065, reporting on Schedule E instead. Elsewhere, a two-spouse LLC is generally a partnership. Check before assuming you can file one Schedule E. For holding structures, see series LLCs for rentals.