Why Some Real Estate Losses Will NOT Reduce Your Taxes

by | BiggerPockets.com

As you probably already know, there are many different types of entities available to investors.

C corporations are often frowned upon due to their issue of double taxation. The corporation pays tax on the profit each year, and then any dividends that are paid to the owners are also taxed. This is a reason why LLCs, partnerships, and S corporations are great options when considering an entity. On the entity side, no federal income tax is paid, and instead the income or loss is factored into your personal tax return as pass-through income.

Pass-through income generates a potentially huge opportunity for tax planning. For example, if you had a year where your S corporation made quite a bit of money, then you can potentially use real estate professional status or a cost segregation study to offset some of that income.

On the other hand, if you have significant losses in your operating business, then perhaps you may want to consider selling some of your appreciated real estate and using the losses to avoid paying tax on the gain of sale. These planning ideas will, of course, depend on your specific tax situation and the type of investments that you have.

year-end-tax-strategies

What comes as a surprise to many investors is that not all real estate losses will result in tax refunds every year. Some investors see that their real estate is expecting a large loss for the year and expect that the loss will offset all of their income. Believe it or not, there are times when a loss on your real estate or business may be useless in reducing your taxes. Here are some examples to take note of.

Related: 3 Tell-Tale Signs You’re NOT Running a Tax-Efficient Business

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Do You Have Enough Basis?

An investor I met last year learned about tax basis the hard way last year. Gina felt confident that she was getting a refund due to the rather large losses generated from her S corporation. This was the first year of business for her S corporation, and it had around $50,000 in losses. It sounded like good news until it came time to prepare her returns. The loss was correct, but she unfortunately couldn’t take the full amount as a deduction on her personal returns. Why did this happen? Let’s take a look:

Gina had only contributed $10,000 of cash into her company during the year, and the rest of the expenses were paid by business loans and credit cards. Since her basis was only $10,000, her losses were limited to that amount. The remaining $40,000 loss was suspended, and Gina was not able to take the rest of the loss until she generated more basis, either through contributions to the company, loans to her company, or through net income in future years.

It is important to know what your basis is in your company, as this is important for taking losses and also taking distributions. This mistake could have been avoided by doing a year-end tax planning. Had Gina been able to contribute or lend her S corporation the additional $40,000, she may have been able to fully benefit from her business losses in that year.

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Is This a Passive or Non-Passive Activity?

Another issue that investors sometimes face is that not all gains can be offset by losses and that not all losses can be taken automatically. Believe it or not, there are actually “different” types of losses in the tax world, and the amount of time that you participate in an activity can have an effect on how much you can take in losses.

Related: The Ultimate Guide to Real Estate Investment Tax Benefits

To be considered a non-passive investor, you have to “materially participate” in the business. Generally, this is defined by:

  • Working more than 500 hours in a business
  • Doing substantially all of the work compared to all other employees and owners combined
  • By working 100 hours without anyone else working more than you

If you are not a real estate professional or your adjusted gross income is above $150,000, your ability to take real estate losses may be limited. The good news is that passive losses do not disappear into thin air. Passive losses are carried forward into future years when they may be used.

Investors: Have any questions about real estate losses and taxes?

Be sure to leave a comment below!

About Author

Amanda Han

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 years with a focus on long-term hold residential and multi-family assets across multiple states. Formerly a tax advisor at the prestigious accounting firm Deloitte in the Lead Tax Group, focusing on tax strategies for the real estate industry and high net worth individuals, and at an international Fortune 500 Company in the high-tech industry in the Corporate Tax department, Amanda’s goal is to help investors with strategies designed to supercharge their wealth building. Amanda’s highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s best seller list. A frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies, Amanda has been featured in prominent publications including Money Magazine, Realtor.com, and AllBusiness.com. Amanda was a speaker at Talks at Google and is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine. She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.

8 Comments

  1. margaret smith on

    Can’t get enough of this kind of clarification! I have an S-Corp- and the ins and outs of it are still often a mystery to me! The benefits seem good, but the maintenance and handling of the books , taxes, planning etc are rather complex. We were all told by the gurus to go out and get LLCs and corps, and so we did, but as I look around at myself and my fellow investors, we are like excited children with unexploded land mines. Whoa!!! Thank you, Amanda.

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