We all love real estate. Investing in rental properties is significantly better than the stock market with respect to returns and tax advantages. Not only can we leverage ourselves to the teeth and see beautiful returns, but our cash flow is usually tax free. That’s the beauty of real estate: the ability to grow wealth relatively tax-free.
Advice from your resident CPA: Use leverage wisely. “Leveraging yourself to the teeth” was a joke, kind of.
It always amazes me that investors analyze deals without ever considering the tax benefits. I want to shake them and yell, “Wake up, dude!” Investing in rentals, and real estate in general, provides significant tax advantages. Why wouldn’t you include them in your analysis?!
For instance, let’s say you are cash flowing $200 per month, but you also have depreciation in the amount of $500 per month. Not only is your $200 monthly cash flow going to come out tax-free, but you’ll have $300 per month in depreciation, or $3,600 annually, that will offset your ordinary income. If you’re in the 28% tax bracket, that’s an additional $1,008 of tax savings that you wouldn’t have had unless you were investing in real estate. That number needs to be a part of your analysis!
By the way, cash flow and net taxable income are rarely the same thing, but for the example above, just go with it.
The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. So what happens when you can’t take advantage of the passive losses because your income is too high?
Phase Out of Passive Losses
When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually. Oh, you’re MAGI is really just your Adjusted Gross Income (AGI) on steroids. But for purposes of our discussion, you can refer to your AGI for simplicity.
As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.
This poses a problem for high income taxpayers, especially when MAGI is above $150,000. High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional. While I love pushing the real estate professional qualification onto my clients, it’s rare that a taxpayer will qualify unless they give up their day job.
Related: 7 Myths About the Real Estate Professional Tax Status, Debunked
What Happens to the Passive Losses We Can’t Use?
When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.
The good news is that you don’t “lose” your passive losses generated from your real estate rental. The bad news is that you can’t use your passive losses today. Personally, I’d rather benefit from those losses today and increase my working capital, through tax savings, to invest for tomorrow. Additionally, if I can’t use my passive losses today, I essentially have a portion of my return on investment (ROI) tied up in the clouds. Not cool.
I have had a number of investors come to me over the past few years who are experiencing problems associated with suspended passive losses. Some of these investors have as much as several hundred thousand dollars of passive losses suspended and being carried forward into future years. This is not good. We want to use those passive losses to see significant tax savings and build tax-free wealth.
Imagine that you have accumulated $100,000 in suspended passive losses over the years. If you’re in the 28% tax bracket, that’s $28,000 you’re leaving on the table. Imagine what you can do with $28,000. If you could have used these passive losses, I bet your ROI on those rentals you own would look a lot better!
Strategy #1 to Tap Into Passive Losses: Buy Cash Flowing Rentals
The first strategy to tap into your passive losses is to buy better performing real estate. You may notice that real estate in a prime appreciation market will produce significant passive losses each and every year. Investing in such real estate will be great for wealth building, but not so great from a tax standpoint since you won’t be able to offset your ordinary income with the losses.
Instead, diversify your portfolio by investing in high cash flow, low appreciation markets. These markets can be scary because they are often secondary or tertiary markets. But with the property due diligence, you can usually squash your worries. Check out the article I wrote about analyzing an out-of-state market. All of these cities should have readily available financial and demographic statements that you can analyze as part of your due diligence.
The high cash flow properties will generally not generate passive losses. This occurs because the relationship between rent and price increases drastically in cash flow markets. For instance, in D.C., we often see a monthly rent-to-price ration of 0.5% to 0.9%, and the properties are going for $700,000. In tertiary markets, you may find a solid rental with a monthly rent-to-price ratio of 1.5% to 2% on properties worth $150,000. Without going into which investment is better or rekindling the whole “2% rule sucks” argument, the point I’m making is that the property generating monthly rent-to-price ratios of 1.5% to 2% will likely have net taxable income even after depreciation.
If this is the case, these properties can be used to tap into the suspended passive losses you are carrying forward. Passive income offsets passive losses without regard to what your MAGI is. So if you have significant passive losses, look into secondary and tertiary markets where the rental yield relative to price is much better.
It pains me to say this, but turnkey properties are a good example of high cash flowing rentals where the income can be used to offset passive losses. Be very careful with turnkey, though. Often, the benefits you receive today will be far outweighed by the costs you incur in the future.
Strategy #2 to Tap Into Passive Losses: Sell Your Rentals
Another great strategy to tap into your suspended passive losses is to strategically offload your rental properties. The cool thing here is that you don’t have to sell the rental property that has generated the losses, as the losses will offset any type of passive income.
When you sell a rental property at a gain, you must first determine what the gain is. The gain will be the net selling price less your adjusted basis in the property. Your adjusted basis is your original basis, less depreciation.
Once you determine your gain, you must determine how much of that gain amounts to depreciation recapture and how much of that gain is capital. It can take a lot of accounting work and cost a pretty penny.
Related: 3 Common Tax Strategy Myths Taught to Investors at Educational Seminars
But the great thing is that if you have passive losses, the passive losses can be used to offset the gain. This can equate to massive tax savings and is often a fantastic way to liquidate wealth for redistribution in a tax free manner.
Strategy #3 (the Ultimate Strategy) to Tap Into Passive Losses: Invest in a Business
This is my favorite strategy, and few investors utilize it. The best way to tap into your real estate’s suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.
The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!
You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.
You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can’t invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.
Here’s why this strategy is so awesome. First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.
Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.
Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.
This strategy is phenomenal and certainly takes a few years to set up. But trust me, by year 10, you’ll be sipping cocktails on the beach and paying for everything with tax-free income.
Strategy #3.5 to Tap Into Passive Losses: Invest in your Family Member’s Business
To expand upon Strategy #3, if you are seeing your passive losses stack up year after year and your family member is running a business, ask them if you can invest with them for a certain stake of the business. You’ll have some level of trust and will likely already know what their work ethic is like, so your risk of total loss is likely reduced. Additionally, it’s relatively difficult to find small businesses who are actively seeking money partners, and those that are are likely seeking venture capitalists who are going to invest a boat load of money and bring experience to the table.
Would the business owner benefit from your funds? Heck yes.
As an example, I recently took a beach trip with my parents, and the topic of their suspended real estate passive losses came up. Because my business is now doing well and should continue to do so well into the future, I brought the idea up of having my parents invest in my business for an ownership stake. For the capital they’d give me, I’d provide them with a stake in the profits without giving them any sort of control or say so in how I operate.
The benefit for my parents is that the profits I provide them will be tax-free to them since they will be tapping into their passive losses. The profits I provide them will be a business write-off for me, saving me about 45% (federal tax, self-employment tax, state tax) on every dollar.
Additionally, I will now have upfront access to capital. I can then use this money to invest in my business, or I can loan/distribute it to myself and use it to invest in real estate. The latter will allow me to continue building my own portfolio and accelerate my tax-free wealth growth.
What’s really happening here is that I’m benefiting because the profits I’m providing to my parents are coming with a 45% discount (my tax savings), meaning that if I give them $10,000, my “out-of-pocket” is only $5,500 after taxes. On top of that, the $10,000 I give them is tax-free to them since they are offsetting this income with their passive losses. So we’ve turned $10,000 into $14,500. Additionally, I’ll likely use their capital to grow my real estate portfolio, and I’ll focus on building additional tax-free wealth. Best of all, we are keeping these savings and wealth building inside the family.
Passive losses are amazing if used effectively. If you are seeing a high amount of passive losses being carried forward every year on your tax returns, partner up with a family member on a business opportunity. Be the passive investor and earn passive income. All the wealth that is generated will be kept inside the family, and you’ll have an untouchable empire that will be passed down for generations.
Get creative and never let your tax position get you down. We can always find ways to change your facts and help you tap into tax-free wealth.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
How do you position your taxes to help build tax-free wealth? Any questions about the above strategies?
Be sure to leave a comment below!