Passive loss rules are one of the most misunderstood parts of real estate fund investing. Many limited partners see depreciation losses on their K-1s and immediately ask the same question: Why can’t I use these losses to offset my income?

The confusion is understandable. Real estate funds are marketed for their tax efficiency, yet many LPs don’t see immediate tax relief in their first year or two. That disconnect leads some investors to believe depreciation “doesn’t work for them” or that passive losses are somehow wasted.

Neither is true.

This article explains what passive loss rules are, how they apply to limited partners, and why passive losses still play a critical role in long-term after-tax returns—even when they cannot be used right away.

What the Passive Loss Rules Are Designed to Do

The passive loss rules were introduced to prevent taxpayers from using paper losses to shelter unrelated active income, such as wages or professional earnings. Under these rules, income and losses are divided into three categories: active, portfolio, and passive.

Real estate fund investments typically fall into the passive category for limited partners. This means losses generated by depreciation and other deductions are classified as passive losses.

The rule is simple in principle: passive losses can generally offset only passive income, not wages, bonuses, or operating business income.

Why Most LPs Are Classified as Passive Investors

Limited partners are, by definition, not involved in day-to-day operations. They do not make management decisions, sign leases, or oversee construction. As a result, the IRS treats their participation as passive.

This classification applies regardless of how sophisticated or experienced the investor may be. A high-net-worth investor with decades of deal experience is still passive if they are not materially participating in the specific investment.

Because of this, depreciation losses from real estate funds are usually restricted in the year they are generated.

What Happens to Passive Losses You Can’t Use

This is where many LPs misunderstand the system.

Passive losses that cannot be used do not disappear. They are suspended and carried forward indefinitely. These losses sit on your tax return year after year, waiting for one of two events:

First, you generate passive income from another investment that the losses can offset.

Second, the investment that generated the losses is sold.

In either case, the losses retain full value. The benefit is deferred, not eliminated.

How Passive Losses Are Released at Sale

When a real estate fund sells a property and fully exits an investment, suspended passive losses associated with that investment are generally released. At that point, they can offset income generated in the year of sale, including capital gains and depreciation recapture.

For many LPs, this is when depreciation delivers its most visible impact. Years of accumulated losses suddenly become usable, often reducing the tax bill on a large liquidity event.

This release mechanism is why passive losses should be evaluated over the entire life of the investment, not on a year-by-year basis.

Why Passive Losses Still Improve After-Tax Returns

Even when losses are suspended, they improve after-tax performance in two important ways.

First, they reduce taxes at exit, when gains would otherwise be taxed at capital gains and recapture rates.

Second, they defer taxes over time. Deferring taxes allows capital to remain invested and compounding instead of being paid to the IRS earlier.

For long-term investors, the time value of money makes this deferral meaningful, even if the benefit is realized years later.

The $25,000 Exception (and Why It Rarely Applies)

Some investors have heard about a special allowance that permits up to $25,000 of passive real estate losses to offset non-passive income. While this exception exists, it is heavily restricted.

It applies only to investors who actively participate in the management of rental real estate and whose income falls below certain thresholds. For most LPs in real estate funds—especially high-income investors—this exception is phased out entirely.

As a result, it should not be a core assumption in fund-level tax planning.

Real Estate Professional Status and LPs

Real Estate Professional Status (REPS) is often mentioned as a way to unlock passive losses. While REPS can allow real estate losses to offset active income, it applies only if strict requirements are met.

Even then, REPS does not automatically apply to all real estate investments. The investor must materially participate in each activity, which is rare for limited partners in large funds.

Most LPs should assume passive loss treatment and evaluate investments accordingly.

How Passive Loss Rules Interact with Depreciation and Cost Segregation

Depreciation and cost segregation often generate large early-year losses. Passive loss rules determine when those losses can be used, not whether they exist.

From a fund perspective, accelerated depreciation still matters because it increases total deductions available to investors. Even if the losses are suspended initially, they accumulate and enhance future tax outcomes.

This is why sophisticated LPs do not dismiss depreciation simply because it is passive. They evaluate its effect over the full investment cycle.

Why High-Income LPs Benefit the Most Over Time

High-income investors often generate little passive income in early years, making loss utilization appear limited. However, they also tend to invest larger amounts, generating larger pools of suspended losses.

When exits occur, those losses can materially reduce the tax impact of large gains. In many cases, the after-tax difference is substantial.

For LPs focused on long-term capital growth, passive losses function as stored tax efficiency.

Questions LPs Should Ask Sponsors

LPs should understand how a sponsor thinks about depreciation, loss allocation, and exit planning. Clear communication around expected losses, holding periods, and tax outcomes signals sophistication.

Sponsors who dismiss passive loss rules or oversimplify their impact may not be modeling after-tax returns carefully.

Conclusion: Passive Does Not Mean Useless

Passive loss rules do not negate the tax benefits of real estate funds. They simply control the timing.

For limited partners, depreciation losses are best viewed as deferred tax assets that enhance after-tax returns over the life of the investment. When evaluated correctly, passive losses remain one of the most powerful tools available to long-term real estate investors.

The mistake is not having passive losses. The mistake is misunderstanding them.