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Can K1 Losses Offset W2 Income? Yes, Here’s Why Multifamily Investing Is so Powerful at Tax Time

Those with high-paying careers likely know the pains of tax season. The IRS has already taken a sizable chunk out of each paycheck, and come tax season, you might even owe more. High-income individuals and families can run into this issue often if they have RSUs and other company perks that may only pay the supplemental rate instead of ordinary income. As you have likely heard, real estate investing has fantastic tax benefits. Depending on your real estate investment situation, you may receive a K1 and wonder, can K1 losses offset W2 income?

The short answer is: yes! And that’s part of the reason why multifamily investing, in particular, is such a desirable vehicle for top-income families. Here’s everything you need to know about multifamily investing and why those K1 losses can significantly benefit you come tax season.

As always, please discuss your particular tax situation with a qualified tax professional. We are not providing legal tax guidance or advice – we’re just highlighting an existing tax code provision that may apply to you!

 

Can K1 Losses Offset W2 Income?

Here’s Why This Is Beneficial
You may have read the statement above and wondered, “how can losing money be beneficial to me?” In other words, if the multifamily investment is losing money, why would it be beneficial to make?

The answer lies in some fascinating intricacies about taxes. Indeed, there are two types of losses. The first type is a “real-world loss.” These losses directly impact your net worth. An excellent example of this would be if you spent $1,000 to produce an app that only made $100. You lost $900 in the endeavor directly from your bank account, and your net worth decreased by $900.

Then there are “passive paper losses.” These are the types of losses that often occur in real estate. They’re losses for tax purposes and do not necessarily reduce your net worth, even if they are actually “losses.”

Consider the following simple example. Suppose you buy a home for $500,000 that requires $20,000 in renovations to put on the market. As per the IRS rules, you can also depreciate the structural part of the property over its useful life of 27.5 years. Suppose the structure is worth about $100,000, which would be an extra $3,600 in depreciation.

But those $20,000 renovations probably increased your home’s value by $50,000 (maybe even more). And that depreciation isn’t money out of your pocket – it’s amortizing the structure’s estimated lifespan and using that as a deduction amount.

You’re out $20,000 cash, yet your overall property value has gone up $50k+, and you get to deduct $23,600 against your income (more on these rules later)! This deduction could save you thousands in taxes!

Increasing your net worth and saving money come tax time? Welcome to the world of real estate!

 

What Are the Rules Surrounding Offsetting W2 Income?
As you might imagine, the IRS has rules around this concept to prevent it from being misused.

First, the answer to “can K1 losses offset W2 income” is only entirely true if you have an AGI at or below $100,000. If you had an AGI equal to $100k and the scenario above, your effective income would be $76,400, saving you about $5,500 on your federal tax bill (all while boosting your net worth by tens of thousands).

Between $100,000 and $150,000, you can offset a percentage of your W2 income with K1 losses.

Above $150,000, you can no longer offset W2 income, but you can cancel out all your real estate income with losses. So, in the example above, suppose you invested $20k, took $3,600 in depreciation, and charged $2k per month in rent. Your income would be $24,000 on the property, but you’d have $23,600 in expenses, meaning you’d only pay tax on $400.

 

Cost Segregation: Accelerating Depreciation for Multifamily Investments
The above examples have shown what might happen if someone purchases a single-family home through an LLC (which would issue a K1 showing the losses).

However, one of the best ways to invest in real estate is to buy multifamily properties.

Multifamily properties are often in the millions of dollars (and thus have numerous smaller investors in the LLC). It’s not uncommon for these places to go for $5-$10 million, or even much more! These investments also have shorter duration periods. Usually, a syndication will look to make improvements and hold the investment for about five years before selling the building for a profit.

Cost segregation is an alternative depreciation technique that can be advantageous for these large-scale investments. Essentially, the IRS allows for two depreciation methods: straight-line and cost segregation. Straight-line takes the property and evenly divides the depreciation amount over a fixed time (usually 27.5 years). So, if the property is $1 million, you’d take $36,363 annually in depreciation.

Cost segregation allows qualified professionals to categorize each part of the property into four areas: personal property, land improvements, structures, and land. Specific categories, like personal property, can have much faster depreciation rates than others. Personal property is between 5-7 years, while land improvements are usually around 15.

The net result is that cost segregation allows for much faster depreciation, thereby increasing overall tax savings!

 

Can K1 Losses Offset W2 Income? Yes, and Multifamily Investing Is the Best Way
If your AGI is below $100k, K1 losses can directly offset W2 income. Between $100k and $150k, losses offset at lower rates. Above $150k, paper losses can offset real rental income gains.

Multifamily investing is particularly powerful for this technique as it can take advantage of depreciation methods, like cost segregation, to make investors’ tax bills as low as they can be!

Real estate is truly one of the best investments from a tax perspective! Unlike real estate, no other investment lets you offset other W2 income and minimize your overall tax bill while still adding to your overall net worth.

Indeed, one of the best ways to build net worth is through multifamily investing – and tax rules like this certainly make that process significantly easier!

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