Why Negative Returns Are the Best Thing That Can Happen to Your Passive Investment

Most new passive real estate investors think that a property that generates a high income is the ideal investment. After all, isn’t earning the highest possible income from a real estate investment what it’s all about? Surprisingly, that may not be the case, and negative returns may be the best thing that can happen to your passive real estate investment.

Passive investors who are part of a partnership or LLC that owns private real estate enjoy what is known as “pass-through taxation.” This means that 100% of income and expenses related to the investment pass through the corporation to the owners or investors, which is an excellent advantage when it comes to taxes. Investors can use all the tax deferrals, shields and favorable capital gain rates that are paid when the property sells.

There are several ways to show a loss for tax purposes, even though the investment has a positive cash flow, by using various tools.

Profit and Loss on a K-1

Each individual receives a K-1 that shows individual income, losses, deductions and credits from the investment, along with any distributions or contributions that were made during the year and use the K-1 for their tax returns. K-1s are given to each investor in the partnership or LLC and are to be filed with their tax return. The Sponsor, or syndicator, will distribute the K-1s to investors.

K-1’s are an excellent tool as it shows a variety of tax issues related to the investment partnership. It can show losses that are a result of depreciation, which is an important consideration for investors. Real estate incurs losses on the K-1 even though properties produce positive or even significant income. Investors can deduct their pro-rata share of depreciation from operating income to show a loss. K-1s are a valuable tool that helps passive investors monitor their investments, which should be an on-going process.

The upside of a loss on a K-1 is that investors can enter that loss on their income tax return and are able to deduct it from income earned on other investment profits.

Tool #1: Cost Segregation

Another accounting tool that can benefit real estate investors is what is called “cost segregation,” It offers investors unique tax benefits by using accelerated depreciation deductions along with easier write-offs if a property becomes obsolete, broken or is completely destroyed.

Syndicators get an engineering report that segregates the property into four categories: personal property, land improvements, building components and land. The main value of cost segregation is the value of front-loaded depreciation deductions, as well as write-offs of specific building components that require replacement.

One of the top benefits of cost segregation is that most properties that were built or began service after December 31, 1986 qualify as a cost-benefit to investors. The properties that make the most sense for taking advantage of this benefit have a depreciable cost basis of $1 million or more.

So how do you determine if a property has a “depreciable cost basis of $1 million or more?” It’s calculated by taking the property’s cost, minus the estimated property value at the end of its useful life. “Salvage value” is the value that a seller is paid when a buyer purchases the property. If the resulting number exceeds $1 million, you should consider taking advantage of the cost segregation benefit.

Cost segregation has been shown to benefit multifamily properties thanks to accelerated depreciation. This happens in several ways. The first way is by identifying qualifying assets that are unique to multifamily properties. Think of a clubhouse, for example, that has a large common area featuring decorative lighting and window treatments, specialty plumbing, high speed internet and more. Those features are generally considered 5-year assets.

The exterior of a multifamily property usually has security gates, extensive landscaping, fountains, mailbox centers, covered parking and other features. Those are generally considered 15-year assets. Cost segregation studies can identify all of these assets.

Cost segregation also helps to maximize income tax savings by adjusting the timing of deductions. If an asset’s life is shortened, depreciation expense is accelerated. This decreases tax payments during the early period of tangible personal property’s life, freeing up cash for investments or to meet current operating expenses.

Tool #2: CapEx

Capital Expenditure, or “CapEx”, is expenses that goes towards improving or maintaining the property. CapEx can be fully deducted in the year the expense occurred.

Examples of these type of Capital Expenditures would be fixing the building’s HVAC system, or resurfacing the parking lot. Another example is completing roof repairs. The repair simply fixes the problem of a leaky or old roof that has to be replaced, but it doesn’t really extend the life of the roof. So the total expense for that repair can be deducted in the year it happened. This deduction will go against any income and appear on the K-1. Because an LLC is only a pass-through entity, the investors will be able to get their prorated share of the CapEx and can use the loss to offset other income.

Summary

Using a K-1 to show losses on a real estate investment, due to CapEx and depreciation, is a great way to off-set losses from other sources of income. It doesn’t mean that you lost money – your investment can be very profitable and has positive cash flow. However, when you show that your building has depreciated and that you had expenses that were needed to maintain the property, you will be able to show “technical” losses. As a result, you may pay little or no taxes. This is the beauty in real estate investing, which is unique compared to other types of investments.

About the author

Ellie Perlman is a real estate investor who owns over 2,000 units across the US worth over $250MM. Ellie is the Founder and CEO of Blue Lake Capital, a real estate investing firm specializing in multifamily investments. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.

She started her career as a commercial real estate lawyer, leading commercial real estate transactions for Israel’s largest development company. Later, as a property manager for one of Israel's most prominent oil and gas company, she oversaw properties worth over $100MM.

Ellie is a Forbes author on real estate investing, the host of the podcast "That REllie Happened?! Unbelievable Real Estate Stories" and a writer of a weekly blog you can find at www.ellieperlman.com.

Ellie holds a Maters in Law and MBA from MIT Sloan School of Management.

You can read more about Blue Lake Capital at www.bluelake-capital.com and learn more about Ellie at www.ellieperlman.com