A nice benefit of real estate investment is all the potential tax benefits. A well-thought-out real estate strategy can generate tax-sheltered or even tax-free cash flow for years. However, as any seasoned real estate investor will tell you, there are times when real estate investments generate losses whether from the aggressive use of allowed depreciation (good) or some vacancy or rental loss (bad). Common sense might dictate that those losses could be deducted in the year they occur, but because real estate income losses are always subject to the Passive Activity Loss (“PAL”) rules of the IRS, this is not always the case.
PAL rules are a set of IRS rules that stipulate the losses from a passive activity can only be used to offset income or gains generated from other passive activities. In other words, they prevent investors from using losses incurred from income-producing activities in which they are not “materially involved” to offset ordinary income. And when it comes to real estate, losses are always classified as passive losses.
All is not lost, however. If you don’t have enough passive income or gains to use up all of your passive losses, the losses can be ‘suspended’ and carried forward (but not back) indefinitely until you have passive income to offset with your suspended losses.
There are two exceptions to the PAL rules:
- your income is small enough that you can use the $25,000 annual rental loss allowance, or
- you or your spouse qualify as a real estate professional.
If you earn less than $100,000 a year in household income, you could deduct up to $25,000 in passive losses. As your income increases above $100,000, that $25,000 is phased out at a rate of $0.50 per every $1. By the time your income meets and exceeds $150,000 annually, that deduction goes away.
The other exception to the PAL rules is the one for real estate professionals. Unlike the $25,000 exception described above, this is a complete exemption from the rules--that is, landlords who qualify as real estate professionals may deduct any amount of losses from their other non-passive income. However, make sure you meet the requirements of IRS Sec. 469(c)(7) before you just assume that you qualify here. The bar is set pretty high.
Benefitting from a Suspended Loss
But you might not meet either of the above criteria and, when tax time rolls around, having that suspended passive loss could be extremely irritating; it almost feels as though you might be leaving money on the table. The good news is, you can take advantage of provisions and strategies to tap into your passive activity loss, and minimize your tax liability in a given year.
Add value-add properties in core areas, or strong secondary markets, to your portfolio. Buy properties that require some kind of rehabilitation – and hold on to them for a few years. Under the new tax laws, you can claim 100% of the cost of the improvements in the year in which they’re implemented. This move will generate suspended losses in the first couple of years. However, in the following years, that suspended loss can be applied against the passive investment income you may earn from the asset and thereby increase your after-tax return.
Buy into a syndication, corporate entity or partnership. Investing in a real-estate owning Delaware Statutory Trust (DST), limited liability company (LLC), or limited partnership (LP) can provide you a nice stream of income. Even better, is that you could use suspended losses to offset passive income generated by these passive investment vehicles. There is, of course, no guarantee of income.
Sell your property. Selling a rental asset for gain can help activate suspended passive losses from your other properties. For example, if you sell your duplex for a gain, you could activate the suspended loss created by expenses from your office building. Better yet, combine the use of your suspended losses with a 1031 exchange. The use of your suspended losses reduces your capital gains tax liability and a 1031 exchange can defer the remainder for an extended period of time.
Suspended losses are a reality for many who invest in real estate. Careful planning, along with consultation with knowledgeable professionals, can help your utilized those losses to mitigate your tax liabilities when the time is right.
If you have any questions about the rules regarding suspended losses or how they can be utilized, please visit us at Realized 1031.com or call us at 877-797-1031.
1031 Exchange Guidebook
The 1031 Investor's Guidebook