There are very few topics in multifamily investing that cause more confusion than taxes. Even among our most sophisticated investors, terms like “depreciation,” “paper losses,” and “passive losses” are often used interchangeably and incorrectly. Yet these concepts sit at the heart of why real estate remains such a powerful wealth-building tool.
At RSN, we believe clarity equals confidence. The tax structure of syndications may look complex on paper, but understanding how these mechanisms truly work can make a meaningful difference in your after-tax returns. In this article we will work to demystify one of the most misunderstood (and most frequently misrepresented) areas of real estate investing, depreciation and passive losses. By understanding how they actually work, we want to empower you to make smarter decisions, ask sharper questions, and maximize legitimate tax advantages.
Depreciation vs. Passive Losses: The Core Distinction
Many investors hear that real estate “lets you write off your income” and that is true… but only partly. Depreciation and passive losses are related, but not the same.
- Depreciation is a deduction at the property level, an accounting method that spreads the cost of a building over its useful life. It can offset ordinary income if you are actively involved in the business. For example, operating your own rental portfolio or qualifying as a Real Estate Professional under IRS rules.
- Passive losses, by contrast, are the result of depreciation, as well as other expenses, flowing through to investors in a syndication where they do not materially participate. These losses appear on your K-1 and are governed by IRS §469. They can typically offset only passive income, not wages, consulting income, or business profits.
That distinction is critical, and it is where many operators blur the truth. You are not “getting depreciation you can use against your W-2.” The partnership takes depreciation, which creates a paper loss. That paper loss then passes through to you as a passive loss, usable only within the passive-activity framework.
There are scenarios where passive losses can offset ordinary income, such as when you or a spouse qualify as a Real Estate Professional(REPS), or when specific grouping or short-term rental rules apply. These situations are legitimate, but they are narrow, nuanced, and require documentation. We will explore those advanced cases later in this article.
The distinction is not bad news, it is just reality. Understanding the rules lets you use them strategically instead of being surprised at tax time.
Good News – Bonus Depreciation Is Back
As of January 19, 2025, the One Big Beautiful Bill Act (OBBBA) reinstated 100% bonus depreciation for qualifying property acquired and placed in service after that date. This is excellent news for investors in newly acquired RSN assets. Cost segregation studies will once again allow us to accelerate depreciation dramatically, generating large entity-level deductions in the first year.
However, your personal ability to use those deductions still depends on how your activity is classified under IRS §469. In short, the property may produce a tax loss, but whether that loss reduces your tax bill depends on your broader income picture and participation level.
Understanding Passive Losses (PALs) Under IRS §469
To understand how your K-1 losses work, it helps to look at how the IRS classifies income:
- Active income: wages, self-employment earnings, business income you materially participate in.
- Passive income: income from rental real estate and businesses where you do not materially participate.
- Portfolio income: dividends, interest, and capital gains from stocks or REITs.
Passive losses, called “PALs,” can offset passive income but generally not active or portfolio income. Unused PALs do not vanish; they simply carry forward indefinitely until you have passive income or dispose of the investment.
Other key rules:
- At-risk limitations (§465) and basis limits apply before the passive-activity test. You need sufficient basis and risked capital to claim the loss.
- The $25,000 small-landlord allowance (for those with MAGI under $150k) requires at least 10% ownership and “active participation.” It rarely applies to syndication investors.
- Publicly traded partnerships (PTPs) have their own silos. PALs from one PTP can only offset income from that same PTP.
- Portfolio income (dividends, bonds, REIT payouts, and capital gains) is not passive, so PALs cannot offset it.
How to Maximize the Value of Passive Losses
If you are accumulating PALs year after year, that is not a problem; it is strategy. Think of them as deferred tax assets that can be “unlocked” later. The key is to be intentional about where your matching passive income will come from.
- Pair PALs with Passive Income Sources: Invest in other K-1–generating assets that throw off positive passive income, such as stabilized multifamily holdings or operating partnerships. PALs from one passive activity can offset income from another (subject to the PTP siloing rule).
- Do Not Count on Dividends or REITs: Dividends, bond interest, and most REIT distributions are portfolio income. They cannot absorb passive losses. Align your overall portfolio so that some portion produces genuine K-1 passive income.
- Use Cost Segregation and Bonus Depreciation Intelligently: At the deal level, RSN uses cost segregation to reclassify building components into shorter depreciable lives. With 100% bonus depreciation reinstated, these deductions can create meaningful entity-level paper losses. But remember: they are only as useful as your ability to apply them under §469.
- Avoid the “Self-Rental” Trap: If you own an operating business that rents property from an entity you control, that rent is recharacterized as nonpassive income, while the rental losses remain passive. That mismatch prevents PALs from offsetting the rent income, a common pitfall for entrepreneurs.
- Plan Around the Excess Business Loss (EBL) Rule (§461(l)): Even after clearing the passive-activity hurdle, high-income investors can run into the EBL limitation, which caps deductible losses beyond certain thresholds. The EBL rule is now permanent, with thresholds indexed annually (about $313k single / $626k joint for 2025). Plan with your CPA so allowed losses do not get bottlenecked here.
Advanced Strategies to Unlock or Recharacterize PALs
Once you understand the basics, there are legitimate ways, all well-defined in the tax code, to unlock or recharacterize passive losses. Each requires careful documentation.
Full Disposition of the Activity
If you sell or otherwise fully dispose of your entire interest in a passive activity in a fully taxable transaction to an unrelated party, your suspended PALs become fully deductible that year. Partial sales or refinances do not trigger this release.
In practical terms, this rule usually applies when we sell a property outright and investors cash out. When that happens, investors are treated as having fully disposed of their passive activity. Their suspended losses from that deal are released, first to offset any passive income for the year, and then, if losses remain, they can offset ordinary income such as wages or business profits.
If, however, proceeds are rolled into another investment (for example, through a 1031 exchange or reinvestment structure), those losses do not unlock. They carry forward until the final disposition of the ultimate investment.
Qualify as a Real Estate Professional (REP)
Under §469(c)(7), if you or your spouse (on a joint return) spend more than 750 hours and more than half of your personal service time in real-property trades or businesses, rental activities are not per se passive. If you also materially participate, the losses from those activities can offset active income, including W-2 wages and business income.
However, this treatment applies only to properties in which you personally materially participate. Simply holding K-1s from syndications does not make those losses eligible to offset active income, even if you meet REP status. The IRS treats each activity separately unless you make a specific aggregation election.
Note for limited partners: LP investors generally can only meet material participation under tests 1, 5, or 6 of Reg. §1.469-5T. This makes REP qualification difficult without active involvement in operations.
Make the Aggregation (Grouping) Election for Rentals
To extend REP treatment to passive investments, taxpayers can file an election under Reg. §1.469-9(g) to treat all rental real estate interests as a single combined activity. This grouping allows the material participation tests to be applied across the entire rental portfolio, including syndicated investments, rather than property by property.
This is an advanced tax strategy that must be executed carefully and under the guidance of a qualified and experienced CPA who can evaluate your eligibility, prepare the proper documentation, and advise you on potential audit risk or compliance issues. The election is binding going forward, and because the grouped rentals are treated as one activity, you generally must dispose of the entire grouped activity to release suspended losses.
When done correctly and legitimately, this approach can be extremely powerful. If your circumstances allow you to qualify as a Real Estate Professional and make a proper aggregation election, the large passive losses generated by multifamily syndications can offset substantial amounts of ordinary income, significantly reducing taxable income in high-earning years.
If you missed the election in prior years, late election relief may be available under Rev. Proc. 2011-34.
Understand Broader Grouping Rules
Beyond the REP-specific election, Reg. §1.469-4 allows grouping of related trades or businesses into “appropriate economic units” for material participation testing. But you generally cannot group rentals with non-rental activities under the REP rules. These groupings affect how “former passive” activities are treated after reclassification and at sale.
Short-Term Rental (STR) Nuances
If the average stay is seven days or less (or up to 30 days with significant services), the activity may not count as “rental” under the regulations. If you materially participate, the losses may be nonpassive without REP status, but this is highly fact-specific and often constrained by local laws.
What It Means for RSN Investors
At RSN, we design each investment with both operational and tax efficiency in mind. Our cost-segregation studies and bonus-eligible improvements create large paper deductions, which help investors “bank” meaningful passive losses for future use. But we also believe in transparency: these losses do not reduce W-2 income unless you qualify as a Real Estate Professional or sell your interest in full.
That is not a limitation; it is a planning opportunity. By pairing RSN’s deal-level deductions with the right personal tax strategy, investors can create powerful long-term compounding effects: cash flow today, deferred taxes tomorrow, and flexibility when assets sell.
The Bottom Line
Bonus depreciation is not a magic eraser for your W-2, and any sponsor who tells you otherwise does not understand (or is not being honest about) the tax rules that govern syndications. Passive losses are incredibly valuable, but only when you know how to use them. The investors who take the time to understand these distinctions, or who work with CPAs that do, consistently see the strongest after-tax outcomes.
We will continue to structure RSN deals to capture every legitimate tax benefit available and to educate our investors along the way. Knowledge is the ultimate return multiplier, and when it comes to real estate, understanding how your “paper losses” actually work is one of the most powerful tools you can have.
Disclaimers
This article is provided for educational and informational purposes only. While the information herein reflects our understanding of the current tax landscape, RSN Property Group and its principals are not CPAs or tax advisors. There may be inaccuracies, omissions, or changes in law that affect these interpretations. Every investor’s situation is unique, and tax outcomes can vary widely based on individual circumstances, including state conformity to federal law.
We share this information to help you better understand the concepts and to equip you with the right questions to bring to your CPA. Please do not take any action based on this article without first consulting a qualified tax professional.
Happy Investing!
Reed Goossens is an Australian-born real estate entrepreneur, investor, author, public speaker, and an all-around good bloke. Reed got his start in real estate investing back in 2012 when he moved to the US.
