How Can You Offset Passive Losses In Real Estate?

Ordinary income is taxed at some of the highest rates. This is income generated from a regular job. Wealthier clients often generate much of their income passively. However, some of it is still taxed at high ordinary income rates.

However, passive income follows different tax rules from ordinary income. It can only be offset with passive losses. But if your passive income is less than your passive losses, you end up with a net passive loss that gets carried forward. Similar to capital gains losses that are carried forward, the loss can end up being carried around for years.

Rather than dragging a passive loss around for years, there are ways that investors can offset the loss.

What is Passive Income?

Passive income is investments that you are not directly or materially involved in. In other words, you hand your money over to someone, and they do the work to generate income. Stocks, real estate rentals, interest, dividends, and royalties are some examples of passive income.

A passive real estate investment doesn’t mean direct real estate. A passive real estate investment is a fund, syndicate, real estate rental, or REIT. Many real estate investors also have full-time jobs, which of course, generates income that is taxed at ordinary income tax rates.

Passive income-generating investments do carry some risk, which can lead to losses. The rule is that passive losses must be offset against passive income. The investor has a net passive loss if passive losses are larger than passive income.

Offsetting Passive Losses in Real Estate

Here are a few ways to offset passive losses.

Generate More Passive Income

When passive losses are more than passive income, the creative investor may find ways to generate more passive income. As long as these new passive income streams aren’t more than the passive loss, the income won’t be taxed since there is no net income. However, as mentioned above, every investment carries risk.

Section 1231 Losses

Section 1231 gains are taxed at the long-term capital gains rate when held for a year or more. However, 1231 losses can be deducted at ordinary income rates. A Section 1231 asset includes depreciable buildings, which are Section 1250 assets. Losses generally come from depreciation recapture when the building is sold.

Many passive real estate investors get involved with section 1250 properties through a syndicate.

Utilize Carried Forward Passive Losses When Possible

Some investors might have passive income losses from the previous year, which can be used in the current year, increasing the total passive loss and offsetting more passive income. However, whether an investor can deduct a net passive loss is specific to the investor’s tax situation and is a conversation they should have with a CPA.

Real Estate Professional Status

Another option, and probably the most difficult, is qualifying for real estate professional (REP) status. A REP can deduct all of their real estate losses against ordinary income.

Two criteria must be met to become a REP:

1. Work in real estate at least 750 hours a year.
2. Cannot do anything else more than you do real estate.

The above qualifications basically mean you can’t have a full-time job doing anything else. Theoretically, someone could work 41 hours per week as a REP and 40 hours per week at their full-time job. But most people aren’t able to work that many hours. This also excludes many high-income professionals working more than 40 hours per week.

The investor will likely need to manage more than one or two properties to satisfy the IRS. A real estate fund or syndicate as your only real estate income source probably won’t cut it either. 

Offsetting passive real estate losses can be done. It just takes knowledge of how and effort depending on which option(s) you choose. It doesn’t hurt to get a tax specialist involved, either.