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May 23, 2024 | read

66. The Tax Impact of Passive Losses for Limited Partners in Syndicates Explained

Ben Isley

Many high net worth and high income earning individuals are looking for places to invest their capital. As a Limited Partner (LP), what is the tax impact of your investments? Can you use passive losses to your benefit?

On today’s show Brandon and Thomas will discuss how passive losses are treated for limited partners in real estate syndicates.

Is your investment tax advantaged or are you going to be able to use those losses against your ordinary income? How can you use the passive losses to your benefit? This is a main point of confusion for these passive investors.

If you’re not working full-time in a real estate trade or business you aren’t a qualified real estate professional for tax purposes, so your investment would simply be tax advantaged. This means that the losses produced and depreciation expenses are large enough to bring the net income from the property to zero or below zero. At this point, you wouldn’t be paying tax related to the income on this property. What happens to the losses in this scenario?

Typically these individuals can’t take losses generated from rental real estate activity against ordinary income. These losses will be suspended and carry forward indefinitely until liquidation or until passive income is created. The losses would be placed against any gain here.

For example, when investing $100K in a standard syndication that is properly run (value-add, cost segregation, bonus depreciation, etc.), an investor could likely expect to see an $85K – $92K passive loss. The $85K – $92K passive loss is passed back to the investor on form K-1 (primarily thanks to cost segregation and 100% bonus depreciation).

As a limited partner, you aren’t materially participating in the real estate activity. To continue this example, say you have a $200K W2 job. In this situation, you’re phased out of the passive activity loss limitations and don’t qualify as a real estate professional. Your options are essentially nonexistent. This 90K passive loss is still suspended unless you can tap into that loss today. There are three ways you could tap into that loss.

1) Liquidate stake in the syndicate or the syndicate liquidates

2) Create higher amounts of passive income by investing in high cash flow assets, or “better deals”.

3) Liquidate another investment and be left with the net difference

Let’s take a similar situation, but in this example you do qualify as a real estate professional. In this scenario, there is an aggregation election available. This allows the investor to group all rental real estate activities into one activity. Theoretically, a portfolio could be built where material participation is achieved. 

By using the aggregate election, since you materially participate in your personal rental real estate, you can also be considered to have materially participated in your passive syndication investments.

Key: You must have your own portfolio, you must qualify as a real estate professional, and you must materially participate in the rental real estate activity to use those passive losses against your ordinary income.

This aggregation election can be found in IRC § 469-9. It’s important to be careful and consult a CPA when using this election, there are potential hurdles and downsides.

The seven tests of material participation