Cost segregation in syndications and funds

Why sponsors commission studies

A large first-year depreciation deduction allocated to limited partners is a material part of the return proposition in many real estate syndications. On a $30 million multifamily acquisition, a study producing $7 million of first-year deduction is a meaningful number on a K-1.

The allocation question

How that deduction reaches investors depends on the partnership agreement, not on the study. Special allocations must have substantial economic effect under section 704(b), or be consistent with the partners' interests in the partnership.

A study produces the deduction. The operating agreement determines who gets it. Sponsors who promise a specific allocation before the agreement is drafted create problems for themselves.

At-risk and basis limits

A partner cannot deduct a loss exceeding their adjusted basis in the partnership interest, or the amount they are at risk for. Non-recourse financing complicates both — qualified non-recourse financing counts for at-risk purposes in real estate, ordinary non-recourse debt generally does not.

Investors with small capital accounts relative to their allocated loss frequently find the loss suspended at the basis or at-risk level before the passive rules even apply.

Then the passive rules

And after basis and at-risk, the passive activity limits. A limited partner is presumptively passive; a limited partner's ability to use a large rental loss against other income is usually nil unless they have passive income elsewhere.

Honest sponsor materials say this. A pitch deck showing a large first-year loss without addressing basis, at-risk and passive limitations is describing a deduction most investors cannot use immediately.

Timing and K-1 season

Studies need to be complete before the partnership return is prepared, which for a calendar-year partnership means well before 15 March or the extended deadline. Sponsors who commission studies in February for a return due in March create avoidable stress.

We schedule fund work in the autumn for exactly this reason.

Recapture on the fund's exit

Section 1245 recapture on a sale flows through to the partners as ordinary income, which lands differently than the capital gain they were expecting. Modelling the exit at acquisition, and disclosing it, is the difference between a sophisticated sponsor and an optimistic one.