How K-1 Losses Can Offset W-2 Income

Cofounder and Managing Partner of Disrupt Equity. Learn more about our multifamily investment opportunities by visiting our website.

Multifamily investing refers to the process of purchasing real estate properties with more than one unit for the purpose of renting them out to tenants. This is a powerful investment strategy that can provide a steady stream of income and offers tax advantages. One of these benefits is the ability to utilize K-1 losses to offset W-2 income at tax time.

How K-1 Losses Can Offset W-2 Income

When you invest in a multifamily property, you’re likely to encounter depreciation. This is a non-cash expense that the Internal Revenue Service (IRS) allows you to deduct from your taxable income, effectively creating a “paper loss.” The paper loss shows up on the K-1 tax form you receive from the property and can often be used to offset your W-2 income.

Let’s consider a practical example. John is an IT professional with a W-2 income of $120,000 per year. He also owns a 12-unit multifamily property. The property generates $24,000 in net rental income annually, but John can claim $30,000 in depreciation thanks to the building’s wear and tear, improvements and the value of the items inside the property (e.g., appliances and carpeting).

So, despite making a profit on his rental property, John’s K-1 shows a loss of $6,000 ($30,000–$24,000). This loss can be used to offset John’s W-2 income, reducing it from $120,000 to $114,000. As a result, John will only pay taxes on $114,000 instead of $120,000.

It’s important to understand that the rules for offsetting W-2 income with K-1 losses are complex and multifaceted, largely dictated by the IRS. These regulations often hinge on your status as a “real estate professional,” which necessitates specific criteria in terms of hours spent on real estate activities.

Moreover, the IRS stipulates that passive activity losses—such as those from a rental property—can only offset passive income, not active income like W-2 earnings. However, the $25,000 active participation exception allows some taxpayers to offset a portion of their W-2 income if they “actively participate” in managing their rental properties. If an individual’s interest in a rental real estate activity, including that of their spouse, is less than 10% (by value) at any point in time, they shall not be considered actively participating in said activity for that period. It’s always advised to consult with a tax professional to navigate these rules effectively.

Cost Segregation In Multifamily Investments

Cost segregation is another strategic tool that can enhance the benefits of investing in multifamily properties. Essentially, cost segregation is a tax strategy that allows investors to accelerate depreciation deductions on certain elements of a property. Instead of depreciating the entire property over a standardized 27.5 years, cost segregation identifies and separates personal property assets, which can be depreciated over a much shorter timescale—typically 5, 7 or 15 years.

This advanced depreciation can result in significant tax benefits in the early years of property ownership, offering the potential for increased cash flow. However, it’s crucial to engage with a cost segregation specialist or tax professional to carry out a detailed cost segregation study and ensure the strategy is applied correctly.

Cost segregation is not a one-size-fits-all strategy; it must be tailored to each investor’s unique circumstances and goals. For instance, investors in higher tax brackets who anticipate significant income from their multifamily property might find this strategy particularly beneficial. The accelerated depreciation deductions can offset a substantial portion of their income, potentially reducing their tax liability.

Moreover, cost segregation can provide an infusion of cash at a critical time—during the early years of property ownership when expenses tend to be higher. This could be particularly beneficial if unexpected maintenance issues arise or rental income is lower than anticipated.

However, investors must also consider the potential downsides. The earlier, larger depreciation deductions mean smaller deductions in later years. If the investor expects to be in a higher tax bracket in the future, this strategy might not be the most beneficial. Furthermore, a cost segregation study can be expensive, typically running into thousands of dollars, so the benefits must outweigh this cost.

Lastly, it’s important to note that cost segregation is a complex area of tax law. Therefore, it’s advisable to work with an experienced cost segregation specialist or tax professional who can carry out a thorough cost segregation study and ensure the strategy is implemented correctly.

Leveraging multifamily investing and utilizing K-1 losses can provide a valuable strategy for offsetting W-2 income during tax time. By taking advantage of this opportunity, investors can potentially reduce their tax liabilities and optimize their overall financial position. With careful planning and implementation, this tax-saving strategy can contribute to long-term financial success.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?