As LP in multifamily: depreciation write off preferred returns?

Question

Most general partners say that the losses you can show after a cost seg study with multifamily will write all all of your income that you received via preferred returns while that property is being held and paying the limited partners (LPs).

However, my CPA says that preferred returns are dividends and cannot be written off with that depreciation.  The depreciation can be saved until later when the property sells and has capital gains, but that is it.  Who's right?

I have a W-2, classified as high-earner, and no real estate professional status.

Michael Plaks · Answer

Paul, I'm pretty sure Ashish and myself are saying the same thing. This clarification may get too technical which I'd rather avoid, but since you asked...

Passive partners have no control over the tax treatment chosen by the CPA who prepares the syndication tax return. They receive their K1s, and whatever the K1 says goes on the investor's tax return, right or wrong.

Partnerships can report their income (or losses) in several different categories represented by various boxes on K1s. Normally, syndications that invest in apartments or commercial properties classify their income and expenses as Rental real estate income and expenses. All income is then offset with all expenses, including depreciation, resulting in a net loss. That net loss is distributed between partners and reported in Box 2 of their respective K1s. This number (usually a negative one) is what goes on the partner's tax return.

Separately, the syndication pays their partners periodic cash distributions, based on whatever compensation formula it adopted. Often it's a preferred return on the invested capital. While these cash distributions do get reported in Box 19 of the partners' K1s, they do NOT create immediate tax consequences. It is neither a taxable income nor a tax loss. Depreciation has nothing to do with this number, either. Spare me the pain of explaining the details.

Now, seemingly some CPAs would take an odd position of treating an investor's preferred return as a dividend and report it not as a distribution in Box 19 but as a dividend in Box 6. It then becomes an additional taxable income, on top of whatever is reported in Box 2. IMHO, this warrants public flogging.

Michael Plaks · Answer

I would not say "most GPs" but certainly a lot of them have no clue about taxes and will tell you anything to promote their syndications as tax-efficient. I wrote about this topic before: https://www.biggerpockets.com/forums/51-tax-legal-issues-contracts-self-directed-ira/topics/996587-explained-tax-consequences-of-k-1-syndications

Preferred return refers to distributions. Distributions themselves do not matter for taxes. What matters is the overall number known as your share of net income or loss from the partnership. This number will be reported on your Form K-1 every year. Typically, this number is negative until the year of sale. The result is that you have no additional taxes despite possibly receiving some cash distributions. Note that I said "typically." Your mileage may vary.

Ashish Acharya · Answer

Stephanie,

I see GP selling you their investment without understanding the rules.  If the preferred return is coming in as portfolio income, the depreciation cannot shield it.  Sometimes GP will treat the LP's return as a preferred return when it is not.

The depreciation can offset other passive income if you have them.

Tanner Glenn · Answer

If the cash payments you are receiving are taxable, your K-1 losses (includes depreciation) will almost always offset that income.

If the cash payments are not taxable, your K-1 losses won't have any income to offset and you'll carry them forward until there is income to offset. That may not come until the property is sold, but you won't miss out on those deductions so long as your CPA keeps track of them year to year.

That is overly simplified and makes a lot of generalizations but I hope it helps.

Paul Moore · Answer

Great question, @Stephanie Brown. I am confused about the two replies above, @Michael Plaks and @Ashish Acharya. Your answers probably make sense to you, but I’m afraid readers, including myself, don’t see you both saying the same thing. I have always believed what Michael said, but I want to understand this better. Can both of you or at least one of you elaborate?

As LP in multifamily: depreciation write off preferred returns?

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