3 tax questions to ask your sponsor before you wire
By Kasing Ng, CPA, former Big 4 fund auditor
The deck shows you a pre-tax IRR. You don't keep that number. You keep what's left after the K-1 runs through your return, and on most deals the biggest tax hit lands in the year the property sells, years after you wired. These three questions take five minutes to ask. A sponsor who has done the work will answer them easily. How they answer tells you as much as what they say.
"What's the after-tax IRR for a passive investor in my bracket?"
The pre-tax IRR assumes every dollar of distributions and sale proceeds is yours. It isn't. And the paper losses that are supposed to shelter you usually can't touch your salary or business income if you're passive (IRC §469). They sit suspended until the deal throws off passive income or sells.
"At sale, how much of my gain is depreciation recapture, and how much is capital gain?"
Most investors expect 20% on the profit. But the gain at sale includes every dollar of depreciation you deducted along the way, and that part comes back at higher rates. Cost-seg personal property comes back as ordinary income, up to 37%. Straight-line depreciation on the building comes back at up to 25%. Only real appreciation gets the capital-gain rate. A passive investor adds 3.8% NIIT on all of it.
"If you're doing cost seg and bonus depreciation, did your projections model the recapture at exit, and what's the plan for it?"
Bonus depreciation front-loads deductions, which is why it's in the pitch. It's mostly timing: what you deduct now, you give back at sale, often at a higher rate than it saved you if you couldn't use the losses. A 1031 can defer it, but since 2018 an exchange only covers real property, so the cost-seg personal property can be taxed even in a clean exchange.
None of these answers alone is a reason to pass on a deal. Plenty of good operators haven't modeled the after-tax side because no one ever asked them to. But if the answers are vague, you're investing on a number you won't actually receive, and it's worth knowing that before you wire.
How to ask without sounding like an auditor
Sponsors get these less often than they should, so frame it as homework, not a challenge. Paste and edit:
Hi [Sponsor], I'm interested in [Deal] and doing my homework on the tax side before I commit. Three quick questions: 1. Do you have an after-tax IRR for a passive investor? I'm in the [__]% federal bracket in [State]. 2. At sale, roughly how much of the gain do you expect to be depreciation recapture versus capital gain? 3. If you're doing cost seg and bonus depreciation, does the model include the recapture at exit, and is a 1031 part of the plan? Ballpark numbers are fine. Thanks!
Run the numbers yourself
The free exit tax calculator splits a sale into recapture and capital gain and shows what a 1031 would and wouldn't defer. The cost-seg estimator shows whether you can actually use the year-one losses. For the longer version, read what your LPs actually keep.
Free tools and the long version: credevsim.com/exit-tax-calculator.html · credevsim.com/estimator.html
I'm a CPA and former fund auditor with nothing to sell you: no deal, no cost-seg study, no exchange. If you're sizing up a deal, or you're a sponsor who'd rather have these answers ready before the next raise, see a sample after-tax projection or book a short call.
General education, not tax, legal, or investment advice. Rates are federal maximums; your result depends on your full return, your state, and the facts of the deal. Passive-activity treatment (IRC §469) and NIIT depend on your situation, including real-estate-professional status. No engagement is created by reading this page. Kasing Ng, CPA — California License 139270 · credevsim.com