Cost Segregation for Partnerships

Partnerships are pass-through entities that do not pay federal income tax at the entity level. Instead, income, deductions, gains, and losses flow through to the partners, who report their share on their individual tax returns.

The partnership files Form 1065 and issues Schedule K-1 to each partner showing their allocated share of items. Each partner reports their K-1 items on their individual or entity tax return based on the character of the income or deduction.

For cost segregation purposes, the partnership calculates depreciation at the entity level using the reclassified asset lives. The resulting deductions are then allocated to partners based on the partnership agreement.

Partnership depreciation allocation is governed by the partnership agreement and must comply with the substantial economic effect requirements of IRC Section 704(b). By default, depreciation is allocated based on the partners' ownership percentages.

However, the partnership agreement can provide for special allocations, which allow depreciation to be allocated differently than the overall profit and loss percentages. This flexibility is one of the primary advantages of the partnership structure for real estate tax planning.

Special allocations must have substantial economic effect, meaning they must reflect the economic arrangement among the partners and be respected by the IRS. Capital accounts must be maintained properly, and liquidation proceeds must follow capital account balances.

Special allocations allow partnerships to allocate partnership depreciation allocation in a way that differs from the overall profit and loss sharing ratios. This can be used to direct more depreciation to partners who have higher tax rates, more passive income to offset, or who can otherwise use the deductions more effectively.

For example, in a syndication, the sponsor may allocate a larger share of depreciation to limited partners in the early years to maximize the tax benefit for investors, while retaining a larger share of cash flow. This type of allocation must be documented in the partnership agreement and must satisfy the substantial economic effect test.

Understanding how entity structure affects tax planning is critical when evaluating whether a partnership or another entity type is best for your real estate investment.

Each partner has an outside basis in their partnership interest. This basis is increased by the partner's share of income and contributions, and decreased by the partner's share of deductions, losses, and distributions.

Cost segregation increases depreciation deductions, which reduces partner basis. Partners can only deduct losses to the extent of their basis. If depreciation deductions exceed basis, the excess losses are suspended until the partner restores basis through capital contributions, income allocation, or debt.

Capital accounts track each partner's economic interest in the partnership. They are maintained on a book basis and adjusted for contributions, distributions, and allocations of income and loss. Proper capital account maintenance is essential for special allocations to have substantial economic effect.

Real estate syndications commonly use partnerships to pool investor capital and acquire properties. Syndication cost segregation is a key marketing and tax planning tool because it allows the partnership to deliver significant depreciation deductions to limited partners.

Syndication sponsors often perform cost segregation studies at acquisition to maximize first-year depreciation and improve investor returns. The depreciation deductions are allocated to investors based on the partnership agreement, often with a preference to limited partners in the early years.

Investors should understand that depreciation deductions from syndications are generally passive. Unless the investor qualifies as a real estate professional, the deductions can only offset passive income. Suspended losses are carried forward and may be released upon disposition of the investment.

For rental real estate owned by a partnership, the activity is generally passive at the partner level. Passive losses can only offset passive income unless the partner qualifies as a real estate professional and materially participates in the rental activity.

Partners who do not meet the real estate professional tests will have their partnership tax cost segregation deductions treated as passive. If they have no other passive income, the deductions are suspended and carried forward until they have passive income or dispose of their partnership interest in a taxable transaction.

Understanding passive activity limitations is critical before investing in a syndication or implementing cost segregation in a partnership. Work with your CPA to determine whether you can use the losses in the current year or whether they will be suspended.

A Section 754 election allows a partnership to adjust the inside basis of its assets when a partner buys into the partnership or when the partnership distributes property. This election can affect depreciation deductions, including cost segregation benefits.

When a new partner buys into a partnership at a premium, the Section 754 election allows the incoming partner to receive additional depreciation based on the step-up in their share of the partnership's assets. This can be particularly valuable when the partnership has already implemented cost segregation.

The Section 754 election is made at the partnership level and applies to all current and future transactions. Once made, it generally cannot be revoked without IRS consent. Partnerships should consult with a tax advisor before making this election.

When a partner sells their partnership interest, their gain or loss is based on their outside basis in the interest. Suspended passive losses may be released to offset the gain on the sale. However, depreciation recapture occurs at the partnership level when the partnership sells the property, not when a partner sells their interest.

If the partnership sells the property, the entity recognizes gain and recapture, which flows through to the partners on Schedule K-1. Partners then report their share of the gain and recapture on their individual returns.

The tax outcome on sale depends on the partner's basis, the amount of suspended losses, and whether the partnership or the partners are selling. For more on how REIT structures handle cost segregation, review the dedicated REIT page, which discusses similar disposition considerations.

Partnerships offer more allocation flexibility than S-corporations and are the preferred structure for most real estate syndications and joint ventures. The ability to make special allocations allows partnerships to optimize tax benefits among partners with different tax profiles.

S-corporations require pro rata allocation and may be better suited for active businesses where self-employment tax planning is a priority. LLCs can be taxed as partnerships, offering the same allocation flexibility with the added benefit of single-member LLC simplicity for smaller investments.

The entity choice should balance tax, legal, and operational considerations. Work with your CPA and attorney to determine the best structure for your real estate portfolio and cost segregation strategy.