K-1 allocation of cost seg depreciation.

Engineered depreciation enters the partnership return on Schedule K, splits under the operating agreement's §704(b) provisions, and lands on each LP's K-1. The mechanics matter — most failures are upstream of the IRS, in the allocation logic.

Where the deduction enters the return

Engineered cost seg depreciation enters Form 1065 as part of the partnership's rental real estate activity. For the typical syndication structure (MF held through an LLC taxed as a partnership), accelerated depreciation flows to Schedule K, Line 2 (net rental real estate income or loss). It does not enter Line 1 (ordinary trade-or-business income) because rental real estate is treated separately under §469.

The CPA loads the basis schedule into the partnership's tax software, which applies the MACRS depreciation rules per recovery class and produces Year-1 depreciation across the 5-, 7-, 15-, and 27.5-year buckets. With 100% bonus depreciation restored under OBBBA 2025, the entire reclassified portion lands in Year 1.

Each LP receives their share via K-1 (Box 2). The partnership return is filed by March 15 of the year following the tax year; LPs receive K-1s in time to incorporate into their personal returns by the April 15 (or extension) deadline.

When capital % and profit % diverge

§704(b) governs how partnership items — including depreciation — get allocated among partners. The default rule: allocation follows the operating agreement's provisions, provided those provisions have substantial economic effect. The IRS scrutinizes three things: (1) capital accounts are maintained per Treas. Reg. §1.704-1(b)(2)(iv), (2) liquidating distributions follow capital account balances, and (3) deficit capital accounts are restored if required by the agreement.

In well-drafted syndication agreements, depreciation allocation usually mirrors capital interest percentage — the same split as cash distributions during the holding period. Where this diverges is in hurdle-rate / waterfall structures where sponsor carry kicks in only after LPs hit a preferred return. The pre-carry phase typically allocates depreciation to LPs pro-rata; the post-carry phase routes some allocation to the sponsor as profit interest.

For Year-1 depreciation specifically — which is when cost seg's impact concentrates — the deduction almost always allocates to LPs by capital percentage. The waterfall implications matter more in years 2–5 for ongoing depreciation, not the front-loaded bonus year.

What each LP can actually use

Once the K-1 lands on the LP's return, three IRS rules determine usability: §469 passive activity (the deduction can only offset passive income unless an exception applies), §465 at-risk basis (the LP must have basis at risk in the activity, generally limited to capital contributed plus their share of recourse debt), and §704(d) outside basis (deductions cannot exceed the LP's adjusted outside basis in their partnership interest).

For typical LPs (W-2-earning individuals, family offices, retirement accounts), the §469 wall is the binding constraint. Rental real estate losses are passive; LPs without REPS (Real Estate Professional Status) or material participation in a non-passive activity can only offset passive income. Losses suspended under §469 do not disappear — they carry forward and release fully on disposition of the partnership interest. So even when LPs can't use cost seg depreciation in Year 1, they capture it at exit.

Sponsors who personally qualify for REPS (750+ hours/year in real estate trade or business, more than half their personal services) can offset W-2 income with their share. This is sometimes the most valuable single line item on a sponsor's personal return — and one of the structural reasons the syndicator role pays disproportionately well even when carry hasn't triggered.

When new LPs join mid-stream

When an LP acquires a partnership interest at a price exceeding their share of inside basis — for example, a secondary buyer of an interest in an appreciating MF deal — the partnership can elect §754 to step up the new LP's share of inside basis under §743(b). The step-up allocates to depreciable assets, including the components reclassified in the cost seg study. The incoming LP captures fresh accelerated depreciation on their step-up amount, independent of what the original LPs received at acquisition.

This matters most in fund-of-funds structures, rolling-LP funds, and secondary transactions where partnership interests change hands. For a one-time syndication with stable LP composition, §743(b) doesn't apply. For sponsors building fund infrastructure where capital cycles in and out, the §754 election interacts with cost seg in non-obvious ways — coordinate with the fund administrator before the close.