For many real estate investors, the first K-1 partnership tax return can be jarring: the document shows a loss while the bank account shows distributions. This apparent contradiction, according to Steven Libman, founder of Investing With Purpose™, leads investors to misunderstand one of the most valuable features of multifamily investing.
The disconnect stems from depreciation. The tax code allows property owners to deduct the wear and tear of a building over time, even though no cash is spent. For residential real estate, the standard schedule spreads this deduction over 27.5 years. A cost segregation study can identify building components that qualify for shorter schedules of five, seven, or 15 years. Under 100% bonus depreciation, anything on a 15-year or shorter schedule can be pulled entirely into year one.
Consequently, a property can generate real positive cash flow while simultaneously producing a tax loss large enough to shelter that income. "When we are trained to hear loss, we think, 'Oh no, I lost money,'" Libman says. "And in real estate, a K-1 loss usually means the opposite of what's happening in real life. It just means that it's a non-cash expense." The K-1 connects the property's depreciation to the individual investor's tax return.
Many investors also misunderstand what happens to losses they cannot use immediately. Unused losses do not expire; they carry forward indefinitely. If an investor generates $150,000 in K-1 losses but only has $100,000 in taxable income, the remaining $50,000 carries forward to offset future income. "Those carry forward in perpetuity, so that can continue to offset income down the road, not just this year," Libman says. "It's not like if you don't use it, you lose it. You get to keep it." This turns depreciation into a long-term tax asset.
However, the ability to use these losses depends on passive activity rules. Most real estate losses are classified as passive, meaning they can only offset other passive income, not W-2 wages. But the real estate professional designation can change this. A taxpayer who spends at least 750 hours annually in real estate activities, including as an investor or operator, may qualify to offset other income, including W-2 income when married and filing jointly. Libman notes this can be particularly beneficial for couples with one real estate professional spouse.
At Investing With Purpose, cost segregation studies are a standard part of the acquisition process, generating depreciation that flows through to K-1s. The firm treats tax losses as a benefit layered on top of the property's standalone investment case. "We underwrite the property as a standalone, and then the tax benefit is kind of the cherry on top," Libman says. "We never make it part of our underwriting assumptions."
Depreciation does not eliminate taxes permanently; recapture occurs when the asset is sold. But purchasing a new property in the same year as a sale generates fresh depreciation, creating a stacked tax benefit. For investors who view K-1s as mere paperwork, understanding these mechanics is essential for managing capital responsibly. More information on the firm's approach is available at Investing With Purpose.
