When multifamily investors receive their first K-1 partnership tax return, many assume a mistake has been made. The document shows a loss, yet their bank account shows distributions. This apparent contradiction, according to Steven Libman, founder of Investing With Purpose™, leads investors to misunderstand one of the most valuable features of multifamily investing.
The disconnect stems from depreciation. The tax code allows property owners to deduct the wear and tear of a building over time, even though no cash is spent on that wear and tear. For residential real estate, the standard depreciation schedule spreads the deduction over 27.5 years. A cost segregation study, an engineering report that breaks the property into its individual components, can identify elements that qualify for shorter schedules of five, seven, or 15 years. Under 100% bonus depreciation, items on a 15-year or shorter schedule can be fully deducted in year one.
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 says. “And 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, flowing through as a slice of the partnership’s income, losses, and deductions.
One of the most common mistakes is assuming unused losses expire. They do not. If an investor generates $150,000 in K-1 losses but only has $100,000 in taxable income to offset, the remaining $50,000 carries forward indefinitely. This turns depreciation 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. You get to keep it.” Over time, a portfolio of multifamily assets can accumulate a growing pool of carried-forward losses, sheltering income long after the original depreciation was generated. This compounding effect on capital that would otherwise go to taxes can accelerate net worth growth.
However, the ability to use these losses depends on the investor’s tax situation. The IRS classifies most real estate losses as passive, meaning they can typically only offset other passive income, not W-2 wages. But the real estate professional designation can change that. A taxpayer who spends at least 750 hours annually in real estate activities may qualify to use losses against other income, including W-2 income 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 because you’re married and filing jointly,” Libman says. Misunderstanding these rules can lead to undervaluing K-1 losses or applying them incorrectly, creating compliance exposure.
At Investing With Purpose, Libman says the firm runs cost segregation studies as a standard part of the acquisition process, generating depreciation that flows through to K-1s. The firm treats the resulting tax losses as a benefit layered on top of the property’s standalone investment case, not as a substitute for it. “We underwrite the property as a standalone, and then the tax benefit is kind of the cherry on top,” Libman says. “We never make it part of our underwriting assumptions.” Depreciation does not eliminate the tax obligation permanently; there is recapture when the asset is sold. But those who purchase a new property in the same year they sell generate fresh depreciation, creating a stacked tax benefit that continues the cycle. For those treating K-1 documents as paperwork rather than strategy, understanding these mechanics is a baseline requirement of managing capital responsibly.
More information on the firm’s investment approach is available at Investing With Purpose.
