← Tax Smart Real Estate Investors Podcast
Tax Smart Real Estate Investors Podcast
MLRE: K-1 Season Explained: Depreciation, Capital Accounts, and Passive Losses
00:25:41
K-1 season can be confusing for real estate inves…
Loading summary
Transcript29 lines
- [00:05]
A
Welcome to the Major League Real Estate Podcast. A podcast for operators of large scale real estate portfolios. My name is Nathan Sosa and I'm your host. Together with my co host Matt Hamilton, we talk about tax and legal strategies and we bring on operators large portfolios for in depth discussions on how they grow their business. We hope you enjoy. Hey everyone, welcome to another episode of the Major League Real Estate podcast. I'm joined by my co host Tom today and we were just talking about how Tom and he escaped snowy New York into the beautiful sun of Miami. And the greatest winter storm of all times happening in New York right now. While Thompson, is this your first February in Miami or your second?
- [00:41]
B
This is my second February here in Miami. It's definitely colder this time around this year though, I will say than last year, but not as cold as New York. I was just on Facebook and 27 inches in isolate, which apparently if it's that's they're saying is accurate. It's the biggest snowstorm ever, ever in Long Island. And my aunt had a, had a picture of her, of her, of the snowstorm on her Instagram where they were literally snowed in a three foot drift right in front of their house, which is pretty big for Long Island. And here I was. Yesterday it was 87 degrees, today it's 62, which is cold for Miami, but still it's not New York weather for sure.
- [01:17]
A
Tom, your aunt's hanging out by the pool and you're hanging out by the pool, but she's ice skating and you've got. And you're not.
- [01:23]
B
I tell people all the time this is why I moved to Miami. Escape those winners. And this is, this is the exact, this is the perfect case study this year of, of why.
- [01:31]
A
Yeah, that's awesome, Tom. Well, Tom, right now K1s are going out the door. People are trying to look at them, understand. Syndicators are trying to explain to their investors what's happened on their K1s. And so I think just going back to some of the basics and talking about what is depreciation in a partnership. Right? Just going back to our fundamentals and trying to understand how do we get our depreciation, how do we get it allocated. Kind of just going over the basics of everything, right. Since we're in K1 season and talk about it for 20, 25.
- [01:58]
B
Yeah, absolutely. So let's just start with the basics of depreciation. I kind of break that down real quick and I'll toss it back to you. So depreciation is a non cash expense that tracks the deterioration of a building over time. Right. Now, what does that really tangibly mean for us from a tax perspective? Usually if you're buying big multifamily properties, commercial buildings, so on and so forth, you're typically going to use a cost segregation study on your property to break down the various components of, of that property, which could be depreciated faster so that you can rapidly accelerate them with 100% bonus depreciation, which means bigger tax deductions in the first year you acquire that property. And it's usually past pro rata between in a partnership. But in syndications and partnership tax law, we can do things that are very interesting. Now one last thing I will comment on for right this second is that for your limited partners, right, who are in the deal, right, their losses are typically going to be passive for them and not offset their W2 or, or active business income, portfolio income, things like that.
- [02:58]
A
Yep. Running the money, Tom. Right. Like that's absolutely the case is that fortunately LPs are going to be passive. Now that's not a bad thing, right, Tom? That's not a bad thing because they still get those losses. I think we discovered in the past few years that people assume, well, I didn't get the loss, it's passive. I'm just, I'm so. Well, I don't get any deductions. It's just over for me. But that's not the case, is it tomorrow?
- [03:20]
B
No, no. So with passive losses, no, it's not the case. If you do have passive losses, they will be suspended on your personal tax return. So in a partnership, you're going to get those losses passed down through to you on your K1, you're going to report that K1 on your tax return. And if you are a passive investor, you don't have the real estate professional status, those losses are going to remain passive and they will offset other passive income you may have in the same year, or they will be suspended and carried forward to future years where they could offset other passive income you have, maybe from other syndicates that you're invested in or perhaps when the property is eventually sold, you'll have a gain. Hopefully you have a gain. The portfolio performed well or your investment performed well and those losses can be unlocked to offset the gain when the property is ultimately sold. So the good news is that the losses, they just don't vanish and disappear from your tax return. Unless you have the real estate professional status you're making, grouping elections, things of that nature, they're not Going to be able to offset your W2, your active
- [04:16]
A
income from other sources, right on the money, Tom, 100%. So now just FYI, like brought up the cash flow, all that stuff, right? There's like you're not out of the running to be able to take those losses. It's just not going to happen year one. Now on the other side for the gps, they probably can because the general partners, they're running the business. So the ones operating the business are the ones who are pretty much in the day to day. So that turns into active for them. So this is kind of like going through what Tom and I will call 469. But most people, like most people say hey, the active passive conversation, that's kind of what that happens. Now let's go even deeper to depreciation, Tom, like go back to the very, very basics. What even is depreciation? Right. It's like our non paper loss that we get from our cost segregation study, right? So that a lot of times to really get to maximize this, you have to do a cost segregation study. And the cost segregation studies are how we accelerate so many deductions into year one. Now that's because we get, we have certain items, normally we have to depreciate everything over 27 and a half years. But then with the cost seg, we break out those items between normally 5 and 15 year property. Sometimes we find 7 year doesn't happen very often but that's typically how we do that. Now that was actually residential property what I was just talking about. If we have 39 year property, that's commercial, that's different, right? Think of like a commercial square. What are some other like hotels, right. Tom, can you have some other examples for me?
- [05:40]
B
Self storage units, that's gonna be 39 year property. If you're renting anything out for seven days or less, maybe you have an RV park or something like that that you've got, you've acquired with a lot of, you know, RVs. Those are typically going to be residential. Anything that's not residential is considered commercial in the world of taxes. Right. So a little bit different for the brokers out there. If there's any brokers tuning in. You know, commercial properties are above 5 units. Even if you have like a multifamily that's still going to be residential. Anything that's not residential is going to be commercial.
- [06:07]
A
Yep. Great breakdown Tom. What do you think about that? So Tom, one of the other things about bonus, sorry about depreciation, I just gave a little hint where we're going next is depreciation was starting in 2017, 100% from 2017-2018-2019-2021, 2022. But then we had a fall off and to 80% and 60% and we thought we're going to be doomed with 40%. Right, Tom?
- [06:33]
B
Yeah. So for a while, yeah, everybody thought 40% bonus depreciation, 2025, 20%, 2026 and then 2027, the party's over and life's going to suck.
- [06:42]
A
Right?
- [06:43]
B
No, I'm kidding. But thankfully we have 100% bonus depreciation that was brought back and made permanent for properties that were acquired in place in service after January 19, 2025. And that has opened the door and renewed that tax provision, which is I think welcomed by a lot of real estate investors and tax professionals alike.
- [07:01]
A
Right. And that's again going back to how do we get those. Flip back to the cost segregation study. That's how we're able to do all of this. And so like Tom and I are talking about before, if you are like a large commercial real estate operator and you own the property 100 yourself, you get all those losses, great. That's a big time win. If you're not, let's say you've got LP syndicators, etc. And you want to take 100% of those losses. It's a little bit more complicated than that, but I'm bearing the lead. I'm going to bury that leak. We'll get back to it. But so the next thing to talk about, Tom, and partnerships are capital accounts, right? Why do we care about capital accounts, Tom? The reason why is because everybody looks at the little box at the bottom of their K1. Everyone wants to understand, what does that mean? What does my capital account mean? And does it let me take my depreciation deductions or not? And so the answer is yes, you normally can, at least in year one. But Tom, do you mind breaking down a capital count real fast?
- [07:54]
B
Yeah, yeah, no, absolutely. So your, your capital count is basically being your basis, quote unquote, in the partnership. To give you kind of an idea of where this starts with usually if you have a contribution into the partnership, let's call it a cash contribution, let's say you invest $50,000 into a real estate partnership, right? Common situation, happens all over every day. You're going to have a basis of $50,000. Now there's going to be things that are going to increase your basis and there's going to be things that decrease your basis. Things that increase your basis are going to be income that's allocated to you. So we're talking about net income. Right. In real estate we often have losses. We have losses. It's going to decrease our basis. All right? And there's other things in there that can tweak your basis, but those are going to be the two main levers, right? Also, when you make distributions from the partnership, that's going to decrease your basis. So, right, Contributions increase your basis, income increases your basis, but losses decrease your basis. And then distributions or withdrawals, whatever you want to call them, distributions are going to decrease your basis. Now one other thing that can increase your basis is debt recourse. Debt will increase your basis if it's allocated to you. Also in real estate, which is something really unique to real estate, in a sense, you have qualified non recourse debt. Qnr, I forgot the exact. Whatever the little four letter thing is. But qualified non recourse debt typically will also increase your basis if it's allocated to you. So if I went and took out a non recourse loan against, I don't know, my business or a business, right, that's not really going to increase my basis because it's just not. Non recourse debt typically does not. But in real estate, if it's secured by real estate, you typically have qualified non recourse debt which does increase your basis. Now why does this all matter to you? Listening right here. Okay. This is why it matters. If you have losses that are in excess of your capital account, meaning, say you had a basis of $50,000 and a loss of $75,000. And I don't know how that happened, but let's just say it happened right now you're only going to be able to take $50,000 of those losses out of the partnership, flow through to your K1 to your personal return. The rest will be suspended within the partnership moving forward. So that's why your capital account is so important, because you want to make sure that if you're going to be taking depreciation or losses that were generated by depreciation, that you have enough balance in your capital account, you have a positive balance to be able to actually take those losses.
- [10:10]
A
Yeah, totally, Tom. Right. Like capital count and outside basis, they are kind of the same, but not at the same time. Right. So the capital account is not going to take into effect the debt that you're talking about. Right. It's not going to track the debt, it's not going to keep or see those items. But all you have to do is take your capital account and look right above that, top of the K1, add your debt, right? Whether if it's qualified or recourse, that's how you get to your basis at the end of the day, which like you said in real estate, pretty much everything we deal with is going to be corporate qualified and add to our basis. And so that's how everyone is able to take advantage of those losses right now, just FYI. And we'll get to this. Debt guarantees are great for increasing our outside basis. They're not great if we want to allocate more depreciation one direction or not, right? That's not how that actually works. How that actually works is the operating agreement. And Tom and I will do a really good breakdown of operating agreements in another episode. But we want to focus on depreciation and what it looks like in the partnership. And so we're going to move into how does the allocations work. Rent, depreciation. And what I will say is generally how it works is based off your profit loss split. That's typically how it's done. That's how the year one loss, right now it's going to be year one loss. But how to get to that loss, you're going to factor in depreciation, operating expenses and then your rental income, whatever the net of that is. Then you take that percentage times your profit loss share times the overall amount. That's what your split's going to wind up being. Now a lot of times we get questions from operators and going, great, my LPs don't care about getting the losses or they'll get them later. I want all of them now as a general partner. GP Right. They've got big asset management fees, they've got big year one acquisition fees, something like that, they're trying to offset, right Tom? So the question then becomes, do they offset them, how do they offset them? And it's not that easy to do that, right? Because we normally 99% of the time whenever we have a capital account, Basically, tax law says once you get to zero, you have to look and see are all the other capital accounts zero? If they're not, sorry, that becomes an issue. And the big issue that we see a lot of times at Hull CPA is operators GPs don't actually put many if any contributions into the business in year one. Right? Because hey, they're the ones running the sweat equity. They're doing all the work. That's understandable, but it's hard to allocate a bunch of depreciation deductions in that direction when you got no capital contributions. Because you're basically starting at zero already, right, Tom?
- [12:41]
B
Yeah. If you're a GP and you're not putting any money into the deal, you might have some, maybe some non recourse debt allocated to you.
- [12:48]
A
Maybe.
- [12:48]
B
But you know, your capital accounts may not be high enough to take the depreciation that's been allocated to you, right? Let's say you do an 80, 20 split with your investors, right? 80% of the deal goes to your investors and 20% goes to you guys as the operators. And that split can vary, but let's just say that was a split and now all of a sudden you have 20% depreciation but you didn't put in 20% of the capital, right? What happens? Right, you're going to run into some issues there.
- [13:13]
A
Real estate syndication tax is confusing to you. Well, that's why hopefully you listen to the podcast today. Also you should go to our website www.the realestatecpa.com and you'll be able to get access to the ultimate guide to real estate syndicators and sponsors which breaks down everything from preferred returns, depreciation strategies, whether you're a GP or an lp, void cost mistakes and maximize your returns. Download the complete guide free and get the tax credit you need to succeed, right? Think about it like, who's at the economic risk of loss, right? Like I always say, like, okay, who's put up what? Like you just am 20% of capital. If someone put in 20% of the capital, they're technically, if this deal goes bust, that's how the tax code likes to view. This is like, does this go bust? Is this indication like what's the worst case scenario where we are 2008 on our hands, we got a real estate fire sale we have to take advantage of. Let's say everything's worth zero. At the end of the day, who is going to lose? And if it's the person that's put the money in, that's who's going to lose. Now people like, I understand, the same time you could say you can easily make an argument that the operator, the general partner is definitely at risk, right? It's their business and they get nothing out of it. Well, that's a problem there. But they look at the hard dollars that would be liquidated or be returned if the property had to be sold. That's how, that's how you have to look at that essentially. So we always have to ask the question, who is at the risk of loss here, who's on the hook, right? And so great, I guarantee the debt. I'm on the hook now. Well, we also have to ask, well, if you sell a property, are you actually. Right, if you sell a property, is it, what's it going to go for? Are you actually going to have to pay some of the pocket out of that loan or 99% of the time? Tom, they're not going to have to do that. They're going to sell the property, the bank's going to take it and they're not going to have to pay any of that debt off. So that would mean they got a ton of losses that should have gone to the LPs. So it's a complicated matter. And Tom, again, I'm just bearing the lead for all these episodes we're going to do in the future, Tom. It's another episode that I think we'll definitely do a deep dive into. So just FYI there now, Tom, when it comes to allocate like these depreciation allocations has to follow and I think we've talked about this, we haven't actually called this specific topic out, is substantial economic effect.
- [15:19]
B
Yeah.
- [15:20]
A
What does that even mean?
- [15:21]
B
Yeah. So substantial economic effect is kind of what you just alluded to before, who is actually at risk here, right, in the deal. And typically when you put the capital in and the allocations are allocated as such, you're kind of taking care of that, naturally. But now what happens is sometimes within these more sophisticated deals and these partnerships, these syndicates and funds, is the sponsorship group decides to specially allocate certain amounts of depreciation in other directions, right? Sometimes it's towards themselves, sometimes they want to take more depreciation, sometimes it's more towards the LPs. It depends. I think the best way to maybe explain this is by the way of example, right? Let's say that we go back to our 80, 20 split and the general partner, right, they have 20% of the depreciation allocated to them, but they don't have a capital account enough to absorb it, it's going to send their capital count negative, right? And that's all well and good, so long as you're not liquidating the partnership, right? But in the fire sale situation, or perhaps you get to the end of the deal and it's just the way the thing the cookies crumbling for you, right? If your capital count is negative, that means you must restore your capital account, right? And how do you restore your capital account? That is a very good Question. And that's where things can get. It can get dicey. I think in the worst case scenario, you might actually have to contribute cash to restore your capital account, which is. Which nobody really wants to do. But other cases, you can actually have the income or the gain distributed given more to you so that your capital account goes positive. But what that can do for you is perhaps create a phantom tax liability. So the bottom line is. Doesn't sound like there's a really good answer if things go south.
- [17:02]
A
No, there's not. Right. I don't think a lot of times this is why we don't see this happen very often. Right. This is the qualified income offset is the QIO agreement is typically what 99% of partnership agreements have. Sometimes you will see the deficit restoration obligation DRO get established. When someone wants to take depreciation losses, it's the only way you can do it. It's literally the only way they can make it happen. However, people just don't want to go after it. Right. Because like you were saying, Thomas, you take a million dollars in depreciation deductions. Correct. And you have no capital contributions. Sweet. No problem. This means you have to put back in a million dollars down the road. And that is painful to do when you don't have the cash to do so. Right, Tom? So just an FYI, a little bit of historical context too, is that Tom and I talked about this in context of 469, where it was created because people were abusing real estate as a tax shelter for such a long period of time. They made all these complex rules to keep it from happening ever again. Well, these rules that Tom and I have been talking about when it comes to depreciation allocations were put into existence for the exact same reasons. So all of this, right. Kind of all goes hand in hand and mixes and saying, hey, you gotta make sure you're actually like, there's risk of loss and you're actually being active in doing all of this. Right. So, Tom, we talked a lot about the tax side of it. The next part I'd love to discuss is what should syndicators do to maximize their depreciation benefits for them and their LPs, right. Going forward, are there things that they should be doing or what should they do? What's just like common sense practices they should implement?
- [18:31]
B
Yeah, yeah. So I think for most investors, and I think the majority of syndicators out there, sponsors out there doing deals, you're typically going to want to maximize depreciation. Like Nate saying, the way you do this is through a cost segregation study. Again, you're going to have your commercial or your residential building 27 and a half or 39 years. And that's a little bit chugging along. But if you run a cost segregation study, you could substantially accelerate that depreciation onto the first year. A lot of LPs like that or want that because they're investing in other deals that might be liquidating or they might have income from other deals and want to get that depreciation sooner rather than later. So the cost segregation study is going to typically be the first thing. Now, as a general partner, what you might be able to do if you can qualify as a real estate professional, okay, meaning you're spending more than 750 hours and more than half your total work time in a real property trader business and syndication, certainly in most cases going to be that if you're doing it full time, then you want to make sure that you're, you're doing that. And then you could take the losses that are passed through to you where you do have enough basis to take those losses flowing through to your personal return and use it to offset your income or maybe your spouse's income, maybe your spouse is doing something else, right, that's generating large amounts of income. So that's on the, on the GP side. Now as the LP side, you want to make sure you're keeping track of your form 8552 where your passive losses are so that you make sure you're tracking your passive losses so that you can carry them forward and use them either in the current year or in the future years when you do have passive income or gains from sale pass activities like a syndicate or fund, that's on the LP side. I'll give another footnote for the LPs now if you are an LP and you have your own portfolio that you are directly managing, so maybe you have your own portfolio of 30 rentals or whatever the case may be, and you're qualifying as a real estate professional yourself because you're managing your own portfolio, you're meeting the 500 hour material participation test as a real estate professional, then you can group all of your rental activities together as many people will do. And in that, so your LP investments will be grouped in with the rest of your investments and making your the losses from your LP interests non passive and they can also offset your other income. Now this is also another reason why people do want cost segregation studies. But that's kind of for the GP side of things. And for the LP side of things, that's my take on it.
- [20:41]
A
Yeah, no, it's a great point, Tom. Then on the partnership side too, I think, look, having a partnership agreement where you have a CPA or tax attorney review those, right, that's going to be super important and crucial. Make sure that you understand what you're actually doing, like how the allocation is going to go from a tax perspective. And then also that you understand exactly like you. And they make sure that these rules are IRS compliant. I cannot tell you the number of operate agreements I see that say, oh, hey, I want liquidation rights to be done and profit and loss percentages. But then at another part of the section say they want it done based on equity. Right. Well, that doesn't line up. It's actually confusing. So you got to get those lined and taken care of. And also tracking capital accounts, right? That's what a CPA does. CPAs and tax pros are here to do that. Make sure you find one that's going to do accurately and well for you. The next part is being mindful of your debt. Your debt and your guarantees. That's the next thing too, right? That's awesome. And can potentially let you take more depreciation deductions. But it's not always the answer at the end of the day. Right. It's a double edged sword because like Tom was talking about, you might, hey, take $500,000 in depreciation. That's awesome. But you might have to pay $500,000 back. And last but not least, I mentioned this one already. Stay within the spirit of the law. Why do I say that? The IRS does audit partnerships and they audit these types of allocations and they honestly win more times than they lose in types of these allocations. Why? Because nobody paid attention to them. No one cared. No one looked or made sure that it was within the law of what we call 704B. You're basically just saying, hey, is this actually following the economic risk of loss that's occurring here? So just FYI to everybody that all that exists.
- [22:18]
B
You know, something I see when I talk to a lot of syndicators and fund managers is they work with, they work with attorneys on their, on their entity structure and their operating agreements, their PPMs. And they think they have their. They always think that they have their attorneys have everything covered. And of course their attorneys want to project that, that image. And that's what you're hiring and paying an attorney for. Right. However, what we see all the time, like Nate was saying on the Other side of it is the tax side of it has been ignored or has been not sufficiently inadequately addressed, which can cause issues down the line, which is important. Why you need to also work with the cpa, who's going to come in and help make sure that the tax sections and the relevant, you know, the relevant provisions within the, in, in the operating agreement, the ppms, things like that, are all kind of speaking the same language and, and are actually achieving your intended outcomes. Because I can't take how many times, you know, I've spoken to a syndicator and they're like, oh, we're doing this and we're doing it that way. Then you go and look at their operating agreements like, no, you're not. That's what you think you're doing, but you're not doing it that way. And it can cause problems down the line. So there's two parts of the equation when you're structuring these things, right? There's, there's of course, the asset protection element of it and making sure you have all your legal liabilities taken care of. And when you're raising large amounts of capital from limited partners and you're responsible for that as a general partner, you of course want to make sure you have yourself the legal side of it covered, but you also want to make sure you have the tax side covered. I just think a lot of, a lot of sponsors that I see may not fully understand that the documents you're getting from your attorney may not be 100% complete in the sense that the tax sections of those are accurate for the outcomes that you actually want to drive. And we catch that all the time here at hall cpa. And I always, I just think that people don't see that element of it. They don't. That's what I say. I think you think you have your attorney has it all covered, but I'm not saying all attorneys are like this, but many cases they're not tax attorneys, right, that are going in there and making sure that everything is truly hitting the outcomes that you want. The bottom line is don't neglect having a qualified CPA take a look at your operating agreements and your PMs to ensure that achieves your intended outcomes. That's the bottom line. Right.
- [24:28]
A
And check the show note link below. And we, like you can book call with Tom or I or someone on our team who can help you take a good look at your operating agreement and make sure that you are IRS compliant and that you are following the code and that you understand the outcomes of what you're you understand the outcomes of what you think you're doing and that way you are safe from a tax perspective because it is super important to how it all works together. Everyone, thanks so much for tuning in today. And this has been another episode the Major League Real Estate Podcast. Thanks for listening to the Major League Real Estate Podcast. There are three ways you can connect with us. If you're interested in getting email updates on upcoming shows, go to ww.therealestatecpa.com and subscribe there. If you'd like to explore a tax and accounting relationship with our CPA firm, you can go to www.therealestatecpa.com and fill out a web form to get started. And if you'd like to connect with Matt or I on social media, you can find us on LinkedIn or Twitter. Just search Nathan Sosa, CPA Matt Hamilton, CPA and shoot us a request. We'd love to connect. See you guys next time.