A $125,000 loss on a deal that's doing fine

Hi {{first_name | there}},

Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.

Imagine you open your email in April.

Inside is a K-1 showing a $125,000 loss.

You invested $250,000 in a private real estate deal less than a year ago.

Your stomach drops.

"Did I really lose half my investment?"

As far as you know, the investment is performing according to plan. You've been receiving cash distributions.

You stare at the negative number again. You Google "K-1 loss meaning." You ask Claude AND ChatGPT about it. You think about calling your CPA, but it's 9 PM on a Sunday.

We see versions of this moment with our investors every tax season. I get it. Since I file an extension every year, I'm working through my tax return with my CPA right now, and real estate taxes can feel like another language.

So let's walk through what might actually be happening...

A K-1 reports your share of a partnership's tax activity. And in real estate, taxable income can look very different from economic performance

One of the biggest reasons is depreciation.

In essence, the tax code incentivizes people to own and improve real estate. Real estate owners are generally allowed to depreciate a building over decades, even though depreciation does not require cash to leave the property each year.

A cost segregation study identifies components of the property that can be depreciated more quickly, shifting more depreciation to the first tax year of ownership.

Current tax law has also restored 100% bonus depreciation for many qualifying shorter-lived components identified through cost segregation, making it particularly powerful again. For reference, our operators almost always have a cost seg study done in year one. 

So both realities below are true.

The property could be performing well while generating a significant tax loss on paper.

Alternatively, a large tax loss does not mean the investment is performing well. Real economic losses can also produce a negative K-1.

This is where people sometimes get disappointed.

Receiving a K-1 with a $125,000 loss does not necessarily mean you can deduct $125,000 against your W-2 or business income.

For many passive real estate investors, those losses can generally offset income from other passive activities, including other passive real estate investments. If you cannot use the full loss today, it may be carried forward and used in future years.

In the example above, the investor received $15,000 in distributions during the year. Because of the depreciation allocated to them, that income was not taxable in the year it was received. For many passive investors, this is the most tangible near-term effect: the distributions arrive, and the tax on them is reduced or deferred.

There are exceptions and additional limitations, so your individual situation matters. This is where your CPA and/or tax strategist comes in.

Side note: If you are making good money and/or have a complex tax situation: ensure you work with an amazing CPA and/or tax strategist and move on from your current one if they are mediocre. Taxes are probably your biggest annual expense, so investing in great tax advice will likely pay for itself many times over.

Cost segregation isn't limited to funds or syndications either. If you own rental property directly, you can commission a study yourself, although the potential tax benefit needs to justify the cost. 

I've experienced the impact of depreciation personally. For roughly the last seven years, depreciation flowing through my personal investments in Wellings Capital funds and sidecars has materially reduced my taxable income. 

One final caveat: depreciation can provide a meaningful timing benefit (a tax deferral), but it isn't necessarily free money forever. When a property is sold, some prior depreciation may be subject to recapture.

So when you see a large loss on a K-1 or from a rental property, separate the tax result from the economic result and ask three questions:

1. What created the tax loss?
2. How is the investment actually performing?
3. Can I use the loss on my tax return this year or in the future?

Your sponsor should be able to explain the major drivers of the tax loss and how the investment is performing. Your CPA should be able to tell you whether and how you can use the loss.

If either can't clearly answer the question that belongs to them, that tells you something too.

If you have feedback or if there's a topic you'd like me to cover in a future newsletter, reply to this email. I read every response!

All the best,

Ben Kahle

Managing Partner | Wellings Capital