Having basis for your tax losses
Are you ready to learn? Today we are going to learn about cost segregation and, specifically, when it does not work.
If you scroll through social media you are going to find a ton of people describing Cost Seg studies as the IRS's gift to mankind and a way to "win" with your taxes. Overall it is but there is one caveat that no one talks about that can make or break the entire strategy. That caveat is debt and the categorization of debt as either recourse or non recourse.
To keep the example simple let's assume your multi family has net income of $100K before depreciation. So you went to one of the best Cost seg firms out there and they told you that your cost seg study can accelerate depreciation for you and get you a $500K write off this year. Wow that is amazing!! you are going to have $400K of losses to offset other income and you are stoked. You go to your accountant tell him about your cost seg and he puts it on your return and says "unfortunately you cannot use any of this $400K on your personal return because you do not have the basis for it."
You see, the losses you can take on your personal return are limited to the basis you have in the partnership. If you followed the OPM (other people money) model to fund the downpayment and then you obtained a loan for the balance to build and renovate the property, your basis would be practically zero and you would not be allowed to take any losses until you have sufficient basis.
So what else gives you basis? Recourse debt. Recourse debt means that you are personally liable for the debt the partnership incurred and they can go after your personal assets to satisfy that. Typically, LPs do not have recourse but the operators usually do. If you took on a $500K loan with the other operator you'd both have $250K of recourse debt basis and be able to take losses up to that.
Word of caution: If your LPs do not have recourse on the debt and their basis is minimal, your promise of losses from cost seg strategies goes away and they are going to be pissed at you when their accountant tells them they do not have basis for these losses.
TLDR: Cost segs are awesome. Just make sure you have sufficient partnership basis to actually take these losses on your personal returns. Read those loan documents and understand who has has the recourse liability and make sure that recourse liability is reflected on your K-1.