How Limited Partners Can Use Real Estate Syndication Losses to Offset Active Income
~ By Sean Graham
Introduction
You work hard. You earn well. But you’re also writing a big check to the IRS every year.
What if there were a way to legally shrink that tax bill by investing as a limited partner in real estate syndication deals?
Let's walk through one of the most overlooked tax strategies for high earners: using passive real estate syndication losses to offset active income.
The Default Rule Is Syndication Losses Are Passive
When you invest in a real estate syndication as a limited partner (LP), you're automatically considered a passive investor in the eyes of the IRS.
By default, the losses passed through to you, such as large depreciation losses from a cost segregation study, are passive losses. These losses normally can only offset other passive income (like rental income, passive gains from real estate sales, or distributions from other syndications).
So if you're a W-2 employee, business owner, or professional with mostly "active" income, these passive losses don't automatically reduce your regular taxable income.
By default, the losses passed through to you, such as large depreciation losses from a cost segregation study, are passive losses. These losses normally can only offset other passive income (like rental income, passive gains from real estate sales, or distributions from other syndications).
So if you're a W-2 employee, business owner, or professional with mostly "active" income, these passive losses don't automatically reduce your regular taxable income.
How to Use Passive Losses to Offset Active Income
There is a legal path to turn those passive losses into a tool to offset your active income, but it requires you to meet three specific conditions:
Real Estate Professional Status (REPS)
- You (or your spouse) must qualify as a Real Estate Professional.
- This means spending at least 750 hours per year on real estate activities and more time in real estate than any other job.
Grouping Election
- You must file an election to treat all of your rental real estate activities as one activity under IRC §1.469-9(g).
- This allows you to combine your direct rental properties with your limited partnership interests.
500-Hour Material Participation Test
- You must materially participate across your grouped real estate activities.
- When you have limited partnership (LP) interests like syndications that make up 10%+ of your real estate portfolio, the IRS treats your portfolio as passive unless you personally meet the 500-hour material participation test across your grouped activities. Other material participation tests, like the 100-hour rule, don't apply to LP interests.
Bottom Line: If you meet all three requirements, you can use syndication losses to offset active income like W-2 wages or business profits.
If you don't meet these requirements, your syndication losses are still valuable as they can offset other passive income or be carried forward indefinitely to future years.
If you don't meet these requirements, your syndication losses are still valuable as they can offset other passive income or be carried forward indefinitely to future years.
What Is Cost Segregation and How Does It Work Here?
When you invest in real estate, the IRS lets you deduct the cost of the property over time. That’s 27.5 years for residential properties and 39 years for commercial properties. This is called straight-line depreciation.
But with a cost segregation study, that timeline gets supercharged.
Instead of slowly writing off the entire building, a study breaks the property into components. Think carpet, lighting, appliances, and even landscaping. These items can be depreciated over 5, 7, or 15 years instead of 27.5 or 39 years.
Even better, if 100% bonus depreciation returns (it's currently phasing down under the Tax Cuts and Jobs Act), many of these components can be largely or fully written off in year one.
The result is massive paper losses that can significantly reduce your taxable income, even if the property itself is producing positive cash flow.
Cost segregation is the engine behind the large K-1 losses you often see in real estate syndications. It's what allows high-income investors to generate major deductions without actively managing a property.
But with a cost segregation study, that timeline gets supercharged.
Instead of slowly writing off the entire building, a study breaks the property into components. Think carpet, lighting, appliances, and even landscaping. These items can be depreciated over 5, 7, or 15 years instead of 27.5 or 39 years.
Even better, if 100% bonus depreciation returns (it's currently phasing down under the Tax Cuts and Jobs Act), many of these components can be largely or fully written off in year one.
The result is massive paper losses that can significantly reduce your taxable income, even if the property itself is producing positive cash flow.
Cost segregation is the engine behind the large K-1 losses you often see in real estate syndications. It's what allows high-income investors to generate major deductions without actively managing a property.
What This Looks Like in Practice
Let's say a real estate syndication buys a $10 million property.
- Roughly 20% of the purchase price is land (non-depreciable), leaving $8 million as the depreciable basis.
- The sponsor performs a cost segregation study, identifying that 25%-35% of the basis can be depreciated upfront if bonus depreciation is available.
- That could create $2 million to $2.8 million of first-year paper losses.
Because losses are allocated based on ownership share, every $100K investment might generate around $60K–$90K in first-year paper losses.
Breaking Down the Math
That $60K–$90K range comes from how depreciation works in these deals. When a syndication performs a cost segregation study, around 25%–35% of the building’s value can often be written off in the first year using bonus depreciation. On a $10 million property, that might create $2M–$3M in total losses. If you invested $100K (1% ownership), you’d get 1% of those losses (about $20K–$30K). Add in your share of the regular depreciation, and your total first-year paper loss can easily land between $60K and $90K.
For Example:
- You invest $100K.
- You receive a K-1 showing a $70K passive loss.
- If you (or your spouse) meet REPS, make the grouping election, and materially participate with 500+ hours, that $70K loss could directly reduce your active taxable income.
- If not, the $70K loss can still offset rental income, passive business income, or be carried forward.
Either way, you're unlocking real tax value from a passive investment.
Final Thoughts
Cost segregation and passive real estate syndications aren't just for full-time investors or real estate developers. With the right structure, even high-income professionals can unlock major tax advantages.
If you're serious about using real estate to reduce your taxes, talk to your CPA about:
Final Thoughts
Cost segregation and passive real estate syndications aren't just for full-time investors or real estate developers. With the right structure, even high-income professionals can unlock major tax advantages.
If you're serious about using real estate to reduce your taxes, talk to your CPA about:
- Whether you or your spouse can qualify for Real Estate Professional Status
- Filing the grouping election
- Meeting the 500-hour material participation test
And as always, make sure your deal sponsors are doing cost segregation studies. If they're not, you could be leaving serious money on the table.
Technical Sidebar: What Is a Grouping Election?
Under Reg. Section 1.469-9(g), a qualifying taxpayer can elect to treat all rental real estate interests as a single activity for tax purposes.
Why it matters:
Why it matters:
- Without the election, you'd have to materially participate in each rental activity separately.
- With the election, you only have to meet the 500-hour material participation test across all grouped activities.
This is critical if you're trying to group your limited partnership interests (like syndications) together with your directly owned rental properties to meet REPS requirements.
The election is made by filing a simple statement with your tax return. Once made, it’s binding for future years unless you revoke it with a material change.
The election is made by filing a simple statement with your tax return. Once made, it’s binding for future years unless you revoke it with a material change.
About the Author
Sean Graham, CPA specializes in cost segregation, tax depreciation, and real estate tax savings. As the Chief Technical CPA at Maven Cost Segregation: Tax Advisors, he has overseen 1000+ cost segregation studies, helping investors maximize deductions.