This may be one of the most common questions real estate GPs or syndicators get 🙋‍♂️: "If I invest $100,000, how much loss will I get back on my K1?" It's a tough one because it depends on a lot of factors, and everyone knows "it depends" really means "you can't afford the answer." 🫴

But instead of taking the cheap way out, we're going to take a stab at putting together a formula 🧮 for how to figure your share of losses on a real estate investment. 🏗️ Along the way, we'll learn about some foundational concepts in partnership taxation.

Here's the formula we'll break down in parts:

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K1 Loss = Partner's Capital Ratio * (Capital + Non-recourse Debt) * 1245 Ratio

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K1 Loss -

Okay, so if you don't need a primer on what a K1 is feel free to skip to the next section. ⏭️

But for the uninitiated, a K1 is kind of like a W2 for owners or investors in a partnership or S-Corps (including LLCs). 📰 The K1 reports your share (pro-rata-ish) of income or loss the business reports. Also, like a W2, the IRS receives a copy and will use it to match what should be reported on your 1040. 🔍

People like losses on K1s to the extent they represent "paper losses" only - e.g. real estate. For example, a real estate investment may be appreciating and cash flowing ☝️ but still produce tax losses from depreciation 👇 (especially accelerated depreciation - see 1245 Ratio below).

Investors (some at least) can use these losses on K1s to offset other passive income. Or in some cases, for real estate professionals, can be used to offset other real estate group income. It's the best of both worlds 🌎 - an appreciating asset saving you money on real taxable income. (Caveat - this is not an investment endorsement for real estate. Real estate values do decline. I am not an investment advisor.)

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Partner's Capital Ratio - [K1 Loss = Partner's Capital Ratio * (Capital + Non-recourse Debt) * 1245 Ratio]

This one isn't hard to figure out. You want to know what percentage of total partners contributions your contribution represents. 🤲 For example, if the total "raise" is $1,000,000 and you are contributing $100,000 then your Partner's Capital Ratio is 10%.

An astute tax reader will expect caveats here, and they shan't be disappointed. ⛔️

When there are different types of classes of equity, this ratio gets more complicated. 🫨 For example, if there is a "Class A" that is strictly "preferred returns" and a "Class B" that "sits behind" the Class A in distribution order, we add a layer of complexity. 🍰

In cases of different classes of equity, check to see if the Operating Agreement tax language is "Target Capital" 🎯 (usually includes the words "hypothetical liquidation"). If so, then the losses will usually flow to the lower classes of distribution preference (in our above case, Class B) first. Meaning only if depreciation exceeded the amount of Partners' Capital in Class B would Class A participate in losses. 🫸

So the additional step would be to figure out if (Total Capital + Non-recourse Debt * 1245 Ratio) > Class B Total Capital. If so, then Class A would calculate their Partner's Capital Ratio as (Partner's Class A Capital / Total Partners' Class A Capital) * (Class A Losses / Total Losses). For what it's worth, this is rare - especially with recently sunsetting bonus rules. 😵‍💫

Okay, let's dig our way back out of that rabbit hole 🐰 and keep the party moving.

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Capital + Non-recourse Debt - [K1 Loss = Partner's Capital Ratio * (Capital + Non-recourse Debt) * 1245 Ratio]

Here we're working to figure how much of the asset is available to investors for depreciation out the gate. 🤷‍♂️ So we start with how much cash investors put in the deal and add a specific type of debt, non-recourse.

The reason it's only "non-recourse" debt is because recourse debt is usually debt that is guaranteed by the GPs (sponsors) and therefore represents "basis" for them, not other LPs.

Especially precious to real estate investors 🏆 is a type of non-recourse debt referred to as "Qualified Non-recourse Debt." This is debt that meets specific requirements (issued by bank, borrower is in activity of holding real estate, not convertible, not guaranteed). It's special because the IRS considers it eligible for "at-risk" basis. At-risk basis is what drives the ability to "take losses" on your personal tax return. 🙌

A full blown "what is basis" dive will have to wait for another week. For now, know that we need the amount of non-recourse debt for our back of the napkin math. 📝

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1245 Ratio - [K1 Loss = Partner's Capital Ratio * (Capital + Non-recourse Debt) * 1245 Ratio]

This is usually the slipperiest input to nail down. 🔨

The 1245 Ratio represents the ratio of ("Accelerated Depreciation"-eligible Assets) / (Cost Basis of Property). It's so named because 1245 assets are specific ones in the tax code that are eligible for accelerated depreciation. These are things like improvements, furniture & fixtures, etc. 🪑

This 1245 figure should come from a qualified cost segregation professional after a study is performed. 👨‍💻 Also worth noting that "Cost Basis of Property" includes Land and other non-1245 property like building structure.

So what's an average ratio? It's decreasing 🔻 every year now unless tax reform is passed because of the annual sunsetting 🌅 of bonus depreciation that was written into the 2017 major tax reform.

But let's work through some rough figures:

If you buy an apartment complex for $5,000,000, a quick land ratio would be 20%. So $1,000,000 gone to land. Of the remaining $4,000,000 building basis, 30% is a decent percentage of 1245 (or bonus-eligible) assets. So call it $1,200,000 in 1245 assets.

The last component is the applicable bonus depreciation percentage. This would be determined on "year placed in service" (or year bought for existing assets). If the asset is placed in service or bought in 2024, this is 60%. In 2025, this goes to 40%. Note that there are other types of accelerated depreciation methods like 179, or that even assigning a lower useful life a cost segregation study can be useful. I digress.

This would put the 1245 Ratio in the above example at = ($1,200,000 / $5,000,000) * 60% = 14.4%

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Putting it Together -

If you're still with me, you deserve a medal. 👏👏👏 But instead, let's work through an example:

In this example, an investor would contribute $100,000 and in the first year would receive a $72,000 loss back on the K1 to them. This loss could be used to offset other passive income or, in real estate professional cases, other potentially active income. 🎉

Additional Caveats and Exceptions -

First ⛔️ - obviously depreciation isn't the end-all-be-all of taxable activity inside a real estate investment. But it's a big component and usually year 1 an asset is running break even from a tax standpoint outside of depreciation. There are of course exceptions and you should consult your projections and the property's historical P&L for a more accurate estimate.

Second ⛔️ - there are a lot of assumptions made above about classes of equity. This back of the napkin math works best with a single class of equity.

Third ⛔️ - don't assume that just because you've invested in a real estate deal that you can utilize these losses against your other income. There are hoops to jump through to justify your ability to use the loss. As always, you should seek the help of a professional for your specifics.

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As long as there is real estate, investors will want losses. 🫰And while there are a flurry of variables, this should be a good place to get started understanding how losses flow inside of a partnership.

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