Offset passive income with new passive loss?

Question

Let's say I made a 100k passive LLC syndication investment #1 a few years back. It sold this year with 10k of total cashflow and 50k of appreciation.

If I invest in a new 100k LLC syndication deal #2 this year and it provides $60k worth of accelerated depreciation. Can this be used to offset the passive gains from deal #1?

I heard that the depreciation losses from deal #2 cannot be used to offset capital gains from deal #1.

Jim Pfeifer · Answer

My accountant (Nate Busch) calls this approach the "Lazy 1031" and it can be done with either passive or active real estate.  There are several factors that need to be considered - bonus depreciation/cost segregation, depreciation recapture and the quality of the investments.  Of course, I am not a tax advisor and this is not investment advice, it's just my opinion of how this works!

One of the most important parts of this - it's addressed in some of the replies - is the quality of your second and third investments.  The subsequent investments should be deals you are planning on investing in anyway - they should not be deals you are investing in purely to defer taxes.  As they say, don't let the tax tail wag the dog.  You need to be investing in quality passive syndications or none of this will work.

With syndications, you necessarily lose control because you are not the manager of the asset.  You cannot control the cost segregation or the timing of the sale of the asset.  A cost segregation is effectively an interest free loan from the IRS and either needs to be paid back through depreciation recapture or deferred through additional depreciation on a new asset.  As stated earlier, depreciation recapture is taxed at a higher rate (25%) than capital gains (15-20%).  It is also important to note that any depreciation from a new asset offsets recapture first and cost segregation second.

As an example: Assume you invest $100,000 in a syndication and the cost segregation yields $20,000 of depreciation.  You hold the asset for five years and it is sold for $150,000.  You have $50,000 of capital gain and $20,000 of depreciation recapture.  Assuming your capital gains tax rate is 20% and you made no further investment, you would owe tax of $10,000 on the gain and $5,000 on the recapture.

Now assume you took the $150,000 and invested it in a new syndication and got the same 20% cost seg, so $30,000 of depreciation.  The new depreciation would first offset the $20,000 of recapture then the remaining $10,000 would offset some of the capital gain from the previous sale leaving you with $40,000 of gain.  You would pay 20% tax on the $40,000 and the tax owed would be $8,000 rather than the original $15,000.  If you have other passive loss that you have been carrying from other investments, that could be used to further defer and reduce the tax.

It is important to talk to the sponsors of the deals you are investing in so you understand if they do cost segregations and get an idea of the typical percent of your investment that the depreciation might be.  It is also important to make sure you are not selecting investments only for the presumed tax benefits.  There are some investments (ATM's) that throw off a lot of passive loss that can be used to offset gains and recapture - but they are only worth investing in if the underlying investment is a good one regardless of the tax implications.

I have been using the Lazy 1031 to offset, defer and reduce my taxes for the past few years and it has worked for me.

Michael Plaks · Answer

@Tony Lin

I will repeat the advice given in several earlier replies: you should not be choosing your next investment based on its tax efficiency. Your primary objective in investing should always be maximizing your returns. Tax benefits are a bonus but not the goal on its own.

What I do want to add is that you somewhat misunderstand (or at least do not clearly articulate) how accelerated depreciation affects your taxes. Depreciation amount by itself is meaningless for taxes. So is the size of your investment. What matters is your proportionate share of the syndication net loss which includes depreciation.

Example. You invest $100k in a syndication, along with 19 more investors who bring $100k each. So you have $2M in cash. You buy a $10M commercial property. After counting the total rent income and subtracting all deductible expenses such as mortgage interest, property taxes, insurance, maintenance, utilities, management and so on - the property generates $600k annual income. Simple depreciation of $200k offsets this income down to $400k. You and your partners have $20k of taxable income each. (Totally bogus numbers, just for an illustration.)

Now your syndication does a cost segregation study which produces a $2M first year bonus depreciation. Now, instead of $400k income, your syndication has a $1,600k loss, or $80k per investor. As you can see, it's the net result of everything combined that matters, not just the depreciation. And certainly not your investment amount.

The article that you linked is confusing due to the subtle distinction of technical terms. When your syndication sells a rental property, the appreciation/profit is not capital gain. It is called "Section 1231 gain" which is taxed at capital gain rates but is considered income from passive activity. Therefore, unlike true capital gains, it can be offset with another syndication's losses.

Basit Siddiqi · Answer

The fact that a gain is a 1231 gain isin't the reason that it can net with passive losses.1231 gain just means it is a gain from the sale of business assets.You can theoretically have 1231 gain that is ineligible to net with passive losses.

Paul Moore · Answer

@Tony Lin. I agree with most of the sentiment above that this is a great strategy. Someday it will become more difficult as bonus depreciation goes away.

The most surprising asset for massive bonus depreciation that I’ve seen his mobile home parks. Using a reasonable amount of leverage, many investors get more than 100% of their investment offset as a paper loss in the first year. This sounded unbelievable to me, but the math is quite simple.

As @Jim Pfeifer and others stated, don’t let the tax tail wag the asset dog. Make sure you love the deal and more importantly the sponsor of your new investment first. Happy investing!

Tushar P. · Answer

Yes, but you will need to keep doing it or you will end up paying more taxes than saved. Or you may save taxes but have greater capital losses. Consider the following:

A. Do you think deal #2 will provide profit, or could it go into losses since you are not investing in it for its quality but only to defer taxes from deal#1?

B. If indeed you get lucky and deal #2 exits with profit, the taxes owed on the 50k from deal #1 will be more than the taxes you would have paid if you didn’t invest in deal #2, since depreciation recapture rate is always higher than the long term capital gains rate.

C. To defer the taxes owed in scenario B above, you can invest in deal #3 in the year deal #2 exits. But you will be back to scenario A. Do you think deal #3 will provide profit, or could it go into losses since you are not investing in it for its quality but only investing in it because you are desperate to not pay more taxes than saved.

Even if you get lucky with deal #3 while not investing in it for its quality, you will face the same situation with deal #4 (when deal #3 exits). Or accept that paying more taxes than saved is less risky than losing bigger capital. So be careful before you adopt this strategy, though many people who may benefit from your investment may tell you that you are so smart to have figured out this strategy yourself 😏. Some people could make it work. Maybe you can too. Good luck!

Eddie L. · Answer

*Full disclosure not a CPA*

Certain conditions need to be met but offsetting your capital gain from the disposition of your interest against passive activity losses seem plausible.Pg 79/154 from IRS Audit Guide:"Passive losses are generally deductible only to the extent of passive income. However, current and suspended losses are fully deductible if there is a “qualifying disposition.” Under IRC § 469(g), a “qualifying disposition” requires three criteria:1. Disposition of an entire interest (or substantially all[1])2. In a fully taxable event (where all gain/loss is realized and recognized).3. To an unrelated party.If these three tests are met, losses are fully deductible against non-passive income (unless the taxpayer has basis limitations). Thus, in the year of disposition, losses allocable to the passive activity may offset portfolio and other investment income or may become part of a net operating loss. We have no regulations governing dispositions. Thus, we must look to IRC § 469(g) and legislative history[2] for guidance."Pg 85/154 from IRS Audit Guide: "Reg. § 1.469-2T(c)(2)(i)(A)(2): Gain on disposition generally is passive income if the activity was a passive activity in the year of disposition"

Pg 84/154 from IRS Audit Guide: "Gain on Form 4797 and Schedule D should first offset losses from the same activity. If any gain remains, it offsets losses from other unrelated passive activities."

References

1. IRC 469(g) - Dispositions of entire interest in passive activity

https://www.law.cornell.edu/us...

2. Internal Revenue Service Passive Activity Loss Audit Technique Guide - Chapter 5 Dispositions - Page 79/154

https://www.irs.gov/pub/irs-ms...

Chris Yang · Answer

Being "that" friend, after some study, here's what I found. Assuming all passive activities from below.

1. Sale of SFH rental, get the 1099-S

2. Use Form 4797 to figure out the Net 1231 Gain from the sale on Line 7

3. The Gain from Form 4797 then goes to Form 8582 Part V Column (a) as current year Net income

4. Invest in new syndication deal before year end, get the K-1 with Net loss

5. Net loss from K-1 then goes to Form 8582 Part V Column (b) as current year Net loss

!IMPORTANT!

6. On Form 8582 Part I: Line 2(a) Net income will be offset by Line 2(b) Net loss and Line 2(c) Unallowed loss.

So technically, passive 1231 gain from a sale of SFH rental COULD be offset by the new passive losses from other syndication deals. Thus, reduce/eliminate tax liability.

Lane Kawaoka · Answer

If you are able to implement a real estate professional status tax strategy (REP) you can use passive losses from syndication deals to lower your ordinary W2 income. If not (ie two full-time working spouses) your only other option is going into land conservation deals, solar deals, or oil and gas deals - all of which have some risks.Explained in a different way...1) There are ordinary/W2/active income on one side. Lets call that the :( side.2) And there is the happy side... passive income (syndications, passive partnerships ie medical/dentist offices) and passive losses (depreciation, bonus depreciation via cost segregations common in syndications). You can you passive losses to neutralize/eliminate passive income. Thats what this is the good side and why passive losses are called PALs too for passive activity losses.So there is a barrier between 1) Active Income and 2) Passive Income above. You cannot offset passive losses (PALs) for active income. UNLESS you are are real estate professional status for tax designation purposes and able to create a "grouping/active participation".

So when a deal is successful and sold (full cycle) what happens then?All investors will have to pay back the depreciation recapture (losses taken throughout the hold) and capital gain (the big payout on the end which is sale minus cost basis). But don't despair because although this is the case when you look at it myopically, in reality most investors go into multiple deals accumulating 100s of thousands of passive activity losses in their first few years investing. Those losses do not go away, but they become suspended to be used to offset future passive income and sales/capital events like this in the future. When you exit a deal, what normally ends up happening (like Tom Brady keep winning more Super Bowls) is that you go into two more deals (with now double the amount of capital) and you will likely find that with those new K1s you could result in you having way more passive losses you began with   If you can see where this is going... yes, experienced investors with a lot of capital deployed might have 500k-1M+ suspended passive losses and have not paid taxes in years and do not appear to pay taxes for years! (you can find how much suspended passive losses you currently have on your IRS Form 8582 - which your CPA is likely not giving to you and in that case you should get a new one)

Lane Kawaoka · Answer

Yes done that many times. After a while (dozens of deals) you will have a huge surplus of PALs.

Lesley Resnick · Answer

That is a strategy I regularly use.  I buy and hold (reno) to offset income.  There are a lot details to the process, but it is a great way to limit income taxes.

Offset passive income with new passive loss?

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