A client is considering investing in a real estate limited partnership (RELP). They are in a high tax bracket and are interested in potential tax benefits, but also understand the inherent risks. Which of the following statements about RELPs is most accurate regarding their tax implications?
- ADistributions from RELPs are always fully taxable as ordinary income in the year received.
- BPassive losses from RELPs can generally be offset against active income without limitation.
- CRELPs typically provide significant tax-free income distributions to investors.
- DDepreciation deductions from RELPs can create passive losses that may be used to offset other passive income.
Show answer & explanationAnswer & explanation
Correct answer: D. Depreciation deductions from RELPs can create passive losses that may be used to offset other passive income.
Real Estate Limited Partnerships (RELPs) generate passive income or loss. Depreciation is a non-cash expense that can create passive losses. These passive losses can generally be used to offset other passive income. They cannot typically be offset against active income without limitations (unless the investor is a real estate professional or meets certain income thresholds for a small amount of loss). Distributions are typically a return of capital until the investor's basis is exhausted, then taxable.
Why the other options are wrong
- A. Distributions often include a return of capital (tax-free) until the investor's basis is reduced to zero, then they become taxable.
- B. Passive losses from RELPs generally cannot be offset against active income, subject to passive activity loss (PAL) rules.
- C. While some distributions may be tax-deferred (return of capital), RELPs do not typically provide 'significant tax-free income' in the long term; taxes are deferred, not eliminated.
RELPs and Passive Losses
Real Estate Limited Partnerships (RELPs) generate passive income and losses, primarily from depreciation, which are subject to Passive Activity Loss (PAL) rules and can generally only offset other passive income.
- Depreciation is a major source of non-cash losses in RELPs.
- Passive losses can offset passive income from other sources.
- Cannot typically offset active income unless specific IRS criteria are met.
Memory trick: Depreciation is the gift, passive loss is the lift, but only for passive income's sift.