Depreciation on Multifamily - Offset Ordinary or Capital Gains?

Question

I am curious about what the concensus is when discussing depreciation on a larger 100+ unit multifamily complex with LP investors?

If you have a property that is producing $500K in positive cash flow (income after debt service) and you have $1mil in depreciation, you would have $500k in additional depreciation. This additional depreciation would be split amoungst the investors, correct? When the investors receive their K-1 at the end of the tax year, can this additional depreciation offset their ordinary income and/or capital gains from other business/real estate ventures?

Any help on this would be great. Thanks!

Brian Adams · Answer

@Dan Handford YEP - the investor could offset their 1040 income.

"Could offset" because IRS has passive activity rules that limit the current year deduction with respect to passive investments.

If they can't deduct in the current year and don't have enough other passive income to offset, the passive loss is suspended.

The suspended loss is utilized either when the entity is disposed of or when the investor has future passive income to offset.

Although I am a CPA, I tell the investor to consult with their own CPA or accountant.

Brian Adams · Answer

@Dan Handford for tax purposes and allocations to the investors, at the entity level you would reduce NOI by depreciation expense and interest expense related to debt service.

So let's say you have $500k of NOI and depreciation and interest expense is $1 million leaving a taxable loss of $500k.

The entity has a $500k loss.

Depending on how your operating agreement is drafted on loss allocations between investors and syndicate sponsor, the loss would be allocated as an ordinary loss and NOT capital gains.

Andrew Hogan · Answer

@Tracy Tsoi Yes get another opinion but No don't pay that much.

Tracy Tsoi · Answer

Hi All,

Can you guys help me clear my question. I am a realtor and RE investor. Last year, I had told by several syndicator that I invest to their deal and will receive negative K1 then use those negative K1 to offset my ordinary Income include my commission from 1099 because I am qualify as real estate professional. Now, I am preparing to file my 2019 tax return, my Cpa told me I can't use passive negative K1 to offset my ordinary income include commission because they are different category. Then I call different cpa specialize in real estate, 100% of them said I cannot offset. I can only use to offset the syndicate distribution and capital gain when they sell the apartment.

I then ask one syndicator, she insist and told me I can and ask me find another cpa that can help

She refer me to wealthy ability. Wealthy ability advise there should be a way around but I need to pay their service begin with $10k. may I ask anyone of you know if I can really use that negative K1 to off set? I don’t want to Spend that $10k and end up unable to offset or did something weird in my tax return trigger the audit.  it would be greatly appreciate if any of you can know the answer and help

Yosef Lee · Answer

Great stuff. Exactly what I was wondering and looking for the answer. Thank you Dan, Brian and Paul for the input. By the way Dan, I love your podcast.

Paul Caputo · Answer

@Dan Handford In this situation depreciation will generally only offset passive income from this or other passive investments. It'll usually be split proportionally between the investors depending on ownership unless they're something strange going on in the operating agreement. The exception is if the investor makes less than $100k then they can offset up to $25k on active income, which phases out from $100k to $150k income. Also if the investor qualifies as a real estate professional for tax purposes they can offset active income and passive income with the depreciation.

If the passive losses are more than passive income they're suspended and they'll carry forward and offset passive income next year.

Are you utilizing cost segregation? $1mm in depreciation per year on straight-line would be a pretty big rental property . If the investors can use the additional losses accelerating the depreciation with cost segregation would be a great idea.

Dan Handford · Answer

@Brian Adams So if the investor has a business providing them with $800K in passive income from the business and they receive a K-1 from one of our syndicated investments showing a $50K loss then they could reduce their taxable income from $800K to $750K?

Thanks for all your input so far and I will definitely refer them to their CPA for final decision making on this but I just want to know for my own edification when discussing with potential investors.

NOTE: What about W2 income? Can the depreciation offset W2 income as well or just passive income?

Dan Handford · Answer

@Brian Adams So would this allow the investors to receive K-1 so they can offset their personal ordinary income? Or is this only for the entity itself?

Depreciation on Multifamily - Offset Ordinary or Capital Gains?

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