If you are a veteran to investing in real estate, you are already likely aware of some of the bigger benefits that surround this asset class such as the appreciation on a leveraged asset, which improves cash on cash returns, and even the ability to create tax free cash flows when leverage is coupled with deductions. However, the benefits that are often not fully utilized occur at tax time.
Before describing how to reduce tax obligations we need to make sure that income types are first identified.
There Are Broadly 3 types of Taxable Income
•Active Income – This category consists of earned income such as salaries, wages, bonuses, and commissions.
•Portfolio Income – This category consists of Interest, dividends, and capital gains.
•Passive Income – This category includes rents from real estate and royalties from oil and gas rights.
Your involvement with your real estate business will directly impact your ability to realize tax benefits and impact the classification of the income stream. If you are an arm chair investor in real estate and do not actively participate in the operations the classification of cash flows as a passive income loss source will not be able to reduce active or portfolio income. In fact passive losses may only be used to reduce passive income. In my opinion this completely ignores one of the greatest benefits associated with real estate investing. There are two exceptions that will allow an investor to use passive losses against non passive income. This brief overview should only be viewed as an introduction. The first reference at the end of this post will be able to clarify any additional detail needed.
Exception 1 – Permissible losses capped at $25,000
The first exception will only allow you to deduct up to $25,000 in passive losses against non-passive income. In order to receive this benefit the investor cannot be an arm chair investor and must be actively involved. Active involvement can be broadly defined as substantial when you are deemed the decision maker that decides rental terms, approves expenditure or tenants and other like decisions. The point here is that you are effectively making real estate an active source of income.
Exception 2 – Permissible losses to apply are limitless
The second, and more cumbersome, exception will allow you to take an unlimited amount of real estate paper loss against your other non passive income. This rule is often referred to as the real estate professional rule. This exception will require that the investor work for 750 hours a year in real estate work and materially participate. Some may believe that as a real estate professional working 750 hours per year is all that you need but this is not the case. As is the case with many BP readers this may just be a part time job, and even if you are able to hit the 750 hours you still need to make sure that the second requirement is fulfilled. The second requirement is that 51% of total working hours in the year must be in the field. This means 51% of total hours worked, including your day job. This is when most beginning investors wishing to apply this exception realize that it is not possible. If you have a full time job it is unlikely that you will meet this second hurdle.
If you are contemplating the use of this second exception your records will be vital. My accountant has provided me enough anecdotal evidence over the years of audited investors to convince me to make sure that I line item every single minute in order to defend myself if the need arises. I literally write down my daily tasks in a journal so that I can account for my time spent. This is not much different from what you may already be doing when logging your driving miles to account for vehicle allowances, and it will similarly help you when you need it most and are facing an auditor who is contesting your eligibility.
The one “gotchya” moment that I had my first year as an investor was that I failed to request that all of my properties (at that time just two) be combined in order to account for my hours when gauging my material participation. In other words I defaulted to treating each parcel forcing me to show a minimum number of hours (500) for each and property. Not only is this more cumbersome for recording purposes but it also resulted in a number of hours that simply could not be met. Once I elected to treat properties in a combined manner it will remain in effect until a change is requested. Needless to say this has helped out tremendously.
The IRS link at the bottom of the page will provide more detail on the tests that get used to gauge material participation. The most commonly used one that I have seen is when an investor does not meet the 500 per property requirement but still spends more time than anyone else. This exception will act as a safe harbor and can be beneficial to know when defending yourself and realizing that you may not have hit the 500 hours.
While cash flows, equity appreciation, and general wealth creation are certainly benefits to investing in real estate the benefits associated with using passive losses against non passive income is a benefit that cannot be ignored. I often tell my students that as their income increases in life real estate can act as a great shield against taxes. Our general goal is to not only increase our portfolio wealth but to also reduce our taxable obligations in every legal way possible.