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Written by : Dee Bruer |
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welcome to trowbridge law group another episode on our youtube channel and i hope you're subscribing to our youtube channel and get all of our good information this particular episode is just following along with three i've done uh here recently because it's tax time and so this episode has something to do with the tax law and filing tax returns and this episode is understanding capital account now capital account is really something that the accountant does uh in llc we're going to talk about capital accounts and llcs the llc has a capital account and each individual investor has a capital account and you're interested in your capital account because one of the things that i know happens is people invest let's say a hundred thousand dollars in an llc and at the end of the year they get the first k-1 and on the top of the k-1 it tells them that their capital account is 80 000 and they start calling when i was this indicator that was the the number one reason for calls during the year people not understanding what was happening in their capital account so i made a point of putting together an article and sending it out to my investors prior to the first year once we saw the first year everyone understands how it goes but it's a first year issue with many investors so i'm going to talk about it right now and we're going to see how our capital account our capital account works you're ready here we go understanding capital accounts for investors and llcs so what does a capital account do it tracks the capital in an llc it's an irs set of rules it's kind of not intuitive but it shows up on your k1 everyone's everyone's capital account starts at zero and then it adjusts there are four ways a capital account can adjust it can go up through your capital contribution which adds your capital account so when you send uh this indicator your hundred thousand dollars to start with your capital account goes up it goes down when you get cash distributions so at the end of the year when this indicator sends you ten thousand dollars your capital account goes down you see what it's doing it's measuring what do you have in the offering on a somewhat of a cash basis cash going in increases your capital account cash going out decreases your capital account and then it gets a little hairier here where if you report taxable income that's going to increase your capital account because when theory when you report taxable income you're going to have to write a check so you're going to have more invested in this investment and then taxable losses reduce your capital account in theory if you have a taxable loss and you can take it you're going to get a refund check so that's coming something coming back to you in your capital account and when it's all said and done it has to end at zero the company has a capital account starting at zero ending at zero the uh investor's capital account has to start at zero and end at zero you with me let's go forward okay so here's the results of a property we have a million dollar net operating income income minus expenses we have sixty thousand six hundred thousand excuse me six hundred thousand dollars of interest payments this year and depreciation of six hundred thousand dollars and we have a taxable loss and we have a we have cash to distribute so this is supposedly the best of both worlds we get positive cash flow and we get a taxable loss that's great now our investor is a 25 owner of this llc with 500 000 as the initial investment so let's track their capital account this year it was zero right then they put 500 000 in that takes you up to 500. then their share of the taxable loss which is 25 percent of the 200 is 50 000 that takes their capital account down the cash distributed 50 000 takes their capital account down so at the end of the year they have four hundred thousand dollars in their capital account that's what shows up on the top of their k1 so they wonder how come their 500 000 is now only worth four hundred thousand well it's uh it's just capital accounting here it doesn't mean anything you got fifty thousand dollars of cash in your pocket and you had fifty thousand dollars worth of losses as you might have seen in in the other one the other videos i've done if we're talking about depreciation and passive income we don't know if we can use that loss but that's not important in the capital account it's just accounted for as if we can use it so that's what happens there and this happens every single year so what's going to happen over time generally your capital account is going to go below zero you're going to get enough taxable losses enough write-off and enough cash distribution that over time your capital account goes below zero now unfortunately it has to end at zero so what happens well at the time of the sale you're gonna get cash distributed to you that may very well take you back to zero but if it doesn't there is another thing that will increase your capital account taking you back to zero and that is reporting taxable income let's see here's the capital account at sale the sale price is 3 million this is the net sale price is 3 million the balance of the mortgage is 1 million the sales proceeds 2 million and there's 2 million to distribute well here we go here's our individual investor at this time in my example the individual investor has a negative capital account of four hundred thousand the property produced losses this year fifty thousand the investor is going to get 500 000 of the sales proceeds allocated to them so what's happening we start with 400 in the hole we could go another 400 in the whole and then we go another 500 in the hole because all these things are reducing our capital account so we end up at 950 000 fully accounting for the life of the property the only problem is we have to end up with a zero capital account so what happens we have to go from 950 negative to zero the way you do that is you get allocated taxable income taking your capital account back to zero so this investor would get 950 000 of taxable income allocated to them and then we'd have to decide is it cost recovery is a capital gain that's not important in the capital account it's just we have to have a closing entry of 950 000 now once again the llc has the same thing the llc has a running total of their capital account they do everything we get down to the bottom the llc has to report income to get it up to zero to get the capital account up to zero and ev the llc doesn't report so what the doesn't pay any taxes doesn't really report income it allocates that final entry to all of the investors and this investor is going to get 950 000 allocated to them as their share so that's what the capital account does and we only pay attention to it once a year when we get our k-1s people misunderstand capital account they think that that all cash distributions are taxable they think that uh all tax losses are usable all that none of that really applies to capital account we're just simply measuring what what do you have in your investment you start with 500 in this case you start with zero you go up to 500 through the year
Thanks for your comment Leoma Vanzyl, have a nice day.
- Dee Bruer, Staff Member
Thanks for this interesting article
Thanks krcun0 your participation is very much appreciated
- Dee Bruer
About the author
I've studied image processing at Linfield University in McMinnville and I am an expert in polymer chemistry. I usually feel sad. My previous job was orthodontic laboratory technician I held this position for 2 years, I love talking about car tuning and parkour. Huge fan of James Harden I practice rope climbing and collect sports cards.
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