The US tax code allows for certain businesses and trusts to pass income-tax liability onto the shareholders and partners who have a vested interest in the business. The K-1 tax form reports each individual investor’s share of the partnership’s earnings, losses, deductions and credits from the business, and any contributions or distributions made during the year.

Depreciation + Real Estate

Depreciation is a legal way to claim a loss without having an actual loss.

If you have a property that makes you $5,000 of profit over a year and you are able to depreciate $10,000 over the year, the taxable income is -$5,000 ($5,000 - $10,000).

Even though you put $5,000 in your pocket from the property, you report a loss to the IRS of $5,000. Depending on your tax bracket, this reduces your income tax by around $3,000, making your net profit on the property $8,000.

Benefiting from Real Estate related losses on a K-1

Often with real estate, the losses shown on a K-1 don’t reflect an underperformance from the investment or the loss of capital; it’s simply a “paper loss” that the investor gets from the depreciation. The “paper loss” allows us to keep more from our investments, lowering the passive income taxable amount to as low as $0 in some cases.

When you receive a K-1 loss from your investment, you’re able to reduce your taxable income by the total. This means if you have capital gains from another investment during the same year, you are taxed less on it.

You submit the K-1 with your personal income tax return. If your K-1 is positive, you’ll have to pay the marginal tax rate on that revenue; if your K-1 shows a loss, you won’t have to pay any taxes (aside from federal and state income taxes depending on where you reside).