Depreciation recapture question

Tax, SDIRAs & Cost Segregation
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Depreciation recapture question

Evan Loader
Rental Property Investor · Ann Arbor, MI · Member since 2019 · 71 posts · 67 votes

I have yet to experience depreciation recapture, since none of the syndications I participate in have exited.

My question is this. I have had paper passive losses on all K-1s filed with no passive gains to offset(I’m a W-2 civilian defense contractor so I can’t offset active W-2 income in my situation since I am not a REP) and I have preserved those losses both on my federal return and the state returns I invest in.

I intend to carry those passive losses forward until I exit on a deal and use those losses to offset part of the gain. I know my basis falls due to the depreciation and those carry forward losses should offset that. Assuming I carry losses forward on a deal until exit will I be able to offset the depreciation recapture portion with those suspended losses I carried forward? My concern is if I didn’t get to experience the benefits of the depreciation I should be able to offset it when I sell. I claimed them on my return but since there was no passive gain to offset they carried forward. The key is to carry them forward via suspended loss on your return in order to use them at exit correct?

I appreciate the insight anyone would have on this.

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Lane Kawaoka
Rental Property Investor · Honolulu, HAWAII (HI) · Member since 2011 · 4k+ posts · 2k+ votes
5y

All investors will have to pay back the depreciation recapture (losses taken throughout the hold) and capital gain (the big payout on the end which is sale minus cost basis). But don't despair because although this is the case when you look at it myopically, in reality most investors go into multiple deals accumulating 100s of thousands of passive activity losses in their first few years investing. Those losses do not go away, but they become suspended to be used to offset future passive income and sales/capital events like this in the future. When you exit a deal, what normally ends up happening (like Tom Brady keep winning more Super Bowls) is that you go into two more deals (with now double the amount of capital) and you will likely find that with those new K1s you could result in you having way more passive losses you began with If you can see where this is going... yes, experienced investors with a lot of capital deployed might have 500k-1M+ suspended passive losses and have not paid taxes in years and do not appear to pay taxes for years! (you can find how much suspended passive losses you currently have on your IRS Form 8582 - which your CPA is likely not giving to you and in that case you should get a new one)

PS - I am not an CPA or attorney but I became financially free doing this for myself after 10 years working as a w2 engineer :( and I am sick and tired of seeing highly educated and hard working professionals getting stuck in the rat race because we deserve financial freedom and the option to do more with it.

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  • Lance LvovskyPro Member
    Accountant · Fort Lauderdale, FL · Member since 2013 · 1k+ posts · 753 votes
    5y

    @Evan Loader

    As a passive investor in a syndication deal, the syndication (partnership) would only generate depreciation recapture at time of asset sale, which would flow through on a K-1 to you. It would likely be unrecaptured section 1250 gain which would be a subset of any capital gain you have on the sale allocated to you. Suspended passive losses you have been carrying forward on your return would reduce the gain. The suspended losses can be released upon disposition of an activity (asset sale).

    2Reply
  • Evan Loader
    OP
    Rental Property Investor · Ann Arbor, MI · Member since 2019 · 71 posts · 67 votes
    5y

    @Lance Lvovsky can I infer/conclude then in my scenario examples that depreciation recapture will not result in additional tax owed for the depreciation recapture portion of the gain if I have suspended passive losses to offset it?

    0Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    5y
    Originally posted by @Evan Loader:

    I have yet to experience depreciation recapture, since none of the syndications I participate in have exited.

    My question is this. I have had paper passive losses on all K-1s filed with no passive gains to offset(I’m a W-2 civilian defense contractor so I can’t offset active W-2 income in my situation since I am not a REP) and I have preserved those losses both on my federal return and the state returns I invest in.

    I intend to carry those passive losses forward until I exit on a deal and use those losses to offset part of the gain. I know my basis falls due to the depreciation and those carry forward losses should offset that. Assuming I carry losses forward on a deal until exit will I be able to offset the depreciation recapture portion with those suspended losses I carried forward? My concern is if I didn’t get to experience the benefits of the depreciation I should be able to offset it when I sell. I claimed them on my return but since there was no passive gain to offset they carried forward. The key is to carry them forward via suspended loss on your return in order to use them at exit correct?

    I appreciate the insight anyone would have on this.

    Yes, your suspensed losses that you will have accumulated over the years will offset the gain.  

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    2Reply
  • Lane Kawaoka
    Rental Property Investor · Honolulu, HAWAII (HI) · Member since 2011 · 4k+ posts · 2k+ votes
    5y

    All investors will have to pay back the depreciation recapture (losses taken throughout the hold) and capital gain (the big payout on the end which is sale minus cost basis). But don't despair because although this is the case when you look at it myopically, in reality most investors go into multiple deals accumulating 100s of thousands of passive activity losses in their first few years investing. Those losses do not go away, but they become suspended to be used to offset future passive income and sales/capital events like this in the future. When you exit a deal, what normally ends up happening (like Tom Brady keep winning more Super Bowls) is that you go into two more deals (with now double the amount of capital) and you will likely find that with those new K1s you could result in you having way more passive losses you began with If you can see where this is going... yes, experienced investors with a lot of capital deployed might have 500k-1M+ suspended passive losses and have not paid taxes in years and do not appear to pay taxes for years! (you can find how much suspended passive losses you currently have on your IRS Form 8582 - which your CPA is likely not giving to you and in that case you should get a new one)

    PS - I am not an CPA or attorney but I became financially free doing this for myself after 10 years working as a w2 engineer :( and I am sick and tired of seeing highly educated and hard working professionals getting stuck in the rat race because we deserve financial freedom and the option to do more with it.

    5Reply
  • Eamonn McElroy
    Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes
    5y

    There should be a Form 8582 in your federal tax return package every year.  This form establishes the passive activity loss generated in the current year, the amount carried forward from the prior year, the amount used in the current year, and the amount carried forward to next year.

    Any amount carried forward is generally available to offset passive income from passive activities in future years.

    If the carryovers are large and increasing every year, you'll want to keep the K-1s that generated the losses as part of your substantiation requirements (and not purge them after 3 or 6 years).

    1Reply
  • Paul MoorePro Member
    Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes
    5y

    Hey @Evan Loader. You got some great advice here!  @Lane Kawaoka is right… if you keep investing you should keep getting losses to offset and carry forward.  

    Question for you tax pros:  at some point, if I invest in an asset with permanent depreciation,  like a carbon credit or ATM portfolio, that has no recapture at the end, would that be an option to end the need to reinvest again?  Am I thinking about this clearly?  :-) 

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  • Evan Loader
    OP
    Rental Property Investor · Ann Arbor, MI · Member since 2019 · 71 posts · 67 votes
    5y

    @Lane Kawaoka

    Thanks for the info, I do have the forms 8582 for each year I’ve invested. My current CPA has done an adequate job on that front. I was concerned that my suspended losses I carry forward wouldn’t be able to offset depreciation recapture gains upon exit. Sounds like I can.

    0Reply
  • Tushar P.
    Member since 2019 · 332 posts · 171 votes
    5y
    Originally posted by @Paul Moore:

    Hey @Evan Loader. You got some great advice here!  @Lane Kawaoka is right… if you keep investing you should keep getting losses to offset and carry forward.  

    The catch word here is “keep investing” i.e. keep taking risks that accompanies every investment (including risk of total capital loss) 😏 It’s not a bad strategy for someone very bullish on real estate and not focused on diversification.

    Keep investing just like those who have to keep doing 1031X to avoid paying more taxes (via depreciation recapture) than what they saved (via depreciation).

    https://www.biggerpockets.com/...

    This is an example of someone paying thousands of dollars in tax preparation each year in order to record the suspended losses noted in K-1, or pay more taxes than due upon exit because the losses were not recorded in the tax return. And keep investing to avoid paying more taxes than saved. What happened to the tax benefits of real estate investing? 😉 

    Even with no tax benefits for those with W2, I invest in real estate simply for the sake of diversification. Even when it doesn’t have the upside of non real estate investments. It’s a struggle to want to keep investing in real estate but sticking to the diversification strategy.

    https://www.biggerpockets.com/...

    0Reply
  • Tushar P.
    Member since 2019 · 332 posts · 171 votes
    5y
    Originally posted by @Paul Moore:

    Hey @Evan Loader. You got some great advice here!  @Lane Kawaoka is right… if you keep investing you should keep getting losses to offset and carry forward.  

    Question for you tax pros:  at some point, if I invest in an asset with permanent depreciation,  like a carbon credit or ATM portfolio, that has no recapture at the end, would that be an option to end the need to reinvest again?  Am I thinking about this clearly?  :-) 

    I would think you are right. It’s like renting your car on Turo. You can depreciate the whole amount in 5 years, and if you continue to own the car long enough the value of the car would be close to zero, hence depreciation recapture will be on zero or on very low amount, i.e. the impact of depreciation recapture would be insignificant. Unless you start fitting your car with gold rims to appreciate its value 😉

    By the way, I thought “keep investing” was a good thing 😉

    0Reply
  • Paul MoorePro Member
    Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes
    5y

    @Tushar P. Thanks!  To be clear, I personally plan to keep investing till I die (and beyond God willing).  I was actually asking this on behalf of some of the investors I talk with who ask me if and how they can get off the merry go-round if they want to someday.  Good answers. 

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  • Daniel Han
    Investor · Member since 2019 · 74 posts · 70 votes
    5y

    Even if you keep investing after the deal, you will have to bring new money into it in order to have passive loss to offset the gain from syndication deal exit. At least that's what I calculated last time assuming 7% preferred 16% IRR, exit at 5 years. If you keep rolling your investment, you eventually run out of passive loss.


    0Reply
  • Jacob Rosenkranz
    Investor · Port Hueneme, CA · Member since 2018 · 23 posts · 9 votes
    4y

    If you eliminate passive gains (from the sale of a syndicated property) with passive losses (from depreciation of a new syndication) is the tax on those gains gone forever? I understand the requirement to "keep investing" when you never sell because the depreciation recapture just keeps growing as you build your portfolio. But if you keep rolling funds from syndications that are sold every 5 years or so, I would think the only one that might catch up with you is the last property (assuming you decided to stop investing one day). Is this correct? Hope this makes sense! thanks!

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