Multifamily Investors Misread K-1 Losses: Depreciation Drives Tax Strategy

Multifamily real estate investors in Texas and across the nation often face a puzzling scenario: their K-1 partnership tax return shows a loss, yet their bank account reflects positive cash flow. This contradiction, according to Steven Libman, founder of Investing With Purpose™, leads many to misunderstand one of the most valuable features of multifamily investing. The disconnect between paper losses and real cash is a common source of confusion, rooted in the negative connotation of the word “loss.” In real estate, however, a K-1 loss often signals the opposite.

The mechanics begin with depreciation, a tax code provision that allows property owners to deduct the wear and tear of a building over time without any cash outlay. For residential real estate, the standard depreciation schedule extends over 27.5 years. A cost segregation study, an engineering report that breaks the property into its components, can identify elements with shorter depreciation schedules of five, seven, or 15 years. Under 100% bonus depreciation, anything on a 15-year or shorter schedule can be fully deducted in the first year. This means a property can generate real, positive cash flow while simultaneously producing a tax loss large enough to shelter that income entirely.

“When we are trained to hear loss, we think, ‘Oh no, I lost money,'” Libman explains. “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, delivering the losses generated by the cost segregation study.

One of the most overlooked features is the carry-forward provision. If an investor generates $150,000 in K-1 losses but only has $100,000 in taxable income, the remaining $50,000 does not expire. It carries forward indefinitely, offsetting income in future years. This turns depreciation from a single-year benefit into a long-term tax asset. “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.” Investors who build a portfolio of multifamily assets can accumulate a growing pool of carried-forward losses, creating a compounding effect on capital that would otherwise be paid in taxes.

However, the ability to use K-1 losses depends on passive activity rules. The IRS classifies most real estate losses as passive, meaning they can typically only offset other passive income, not W-2 employment income. For those with W-2 jobs, this creates a limitation. One strategy to overcome this is the real estate professional designation. A taxpayer who spends at least 750 hours annually in real estate activities may qualify to offset W-2 income, especially when filing jointly with a qualifying spouse. “If you have a W-2 spouse and you’re a real estate professional, then that depreciation can actually go and offset some of the W-2 income,” Libman says.

At Investing With Purpose, Libman incorporates cost segregation studies as a standard part of the acquisition process, generating depreciation that flows through to K-1s. The firm treats tax losses as a benefit on top of the property’s standalone investment case, not as a substitute. “We underwrite the property as a standalone, and then the tax benefit is kind of the cherry on top,” Libman says. While depreciation is subject to recapture upon sale, investors who purchase a new property in the same year generate fresh depreciation, continuing the cycle. For those who view K-1 documents as mere paperwork, Libman emphasizes that understanding these mechanics is a baseline requirement for managing capital responsibly.

More information on the firm’s investment approach is available at Investing With Purpose.