Let’s say that you’re the direct owner of a rental property portfolio, and you’ve decided to sell the bulk of it. You’ve decided not to go the 1031 exchange route, understanding that capital gains taxes will be assessed on your profits.
But as you go through the sales activities with your accountant at the end of the year, you realize you might be benefitting from a suspended loss. Your accountant informs you that, under certain situations, you could actually deduct that suspended loss from the profit of your property sale.
“How is this possible?” you ask that tax expert. She then explains it’s possible, due to both the nature of rental property ownership, as well as the role of suspended losses in the overall tax scheme.
Defining suspended losses
Your tax expert might tell you that a suspended loss is defined as a capital loss involving ownership of a capital asset (such as your rental property portfolio). But a loss might be considered “suspended” because you might not be able to actually realize all, or part of it, during a particular tax year. And, the main reason why you might not be able to realize that loss is because the loss is tied to a passive investment.
According to the IRS’ Passive Activity Loss Rule, you can only write off passive losses against passive income gains, unless you qualify as a real estate professional. Assuming you are not, if the passive loss is greater than your passive income in a given tax year, that difference doesn’t just go away. Rather, it becomes suspended. While it might not be able to be used in the current tax year, it could be carried over to the following year or years, and written off against future passive gains.
Direct ownership? Or not?
Your next question might be: “Okay. I understand the idea behind suspended losses. But I’m a hands-on owner of that real estate. How is any of this, in any way, related to passive investing?”
We’ve written a great deal about passive investments, which are defined as investments in which the investor is not a material participant. Interestingly enough, even if you consider yourself an active owner of leased real estate, the IRS considers that most of your losses are passive losses.
And, if the loss is greater than the income, that difference becomes a suspended loss. At least, until the following year when you can write that loss against future passive gains.
Or until you sell the property, or properties.
Ending the suspension
When you close on your rental properties, any suspended loss can be written off against the profit, under the following conditions.
You must sell “substantially all” of your rental property. Selling one property out of a portfolio of five isn’t “substantially all” of your holdings. You won’t be able to write off those suspended losses.
The sale must trigger a taxable event. In other words, the income from the sale must be recognized. This leaves out tax-deferred strategies, such as investment in a Qualified Opportunity Fund, or use of a 1031 exchange.
Is it the right move?
Hopefully you discussed selling the property with your tax advisor or financial planner before actually doing so. While using a suspended loss as a write-off could whittle down your taxable income, it’s not the sole reason to dispose of your investment. There could be compelling reasons to keep that property.
However, just as important as understanding what losses you can and cannot use as tax write-offs is knowing how those losses might impact future sales proceeds. Understanding such issues can help ensure you make the correct investment decisions, including when to buy, sell, or hold.
