Its Time to Clarify the Tax Benefits of Rental Real Estate
Both new and seasoned investors sometimes misunderstand the tax benefits of rental real estate, especially around the concept of tax advantaged income, and weather or not investing in real estate can reduce your overall tax liability, and thus the tax you pay.
- What is tax advantaged income?
- Can real estate investing really reduce your taxable income and the amount of tax you pay?
With so much different (and sometimes conflicting) information out there, the confusion is totally understandable. Read on as we answer these questions and clarify the tax benefits of investing in rental real estate.
Tax Advantaged Income
The first concept we need to understand is tax advantaged income.
Rental real estate investors have the benefit of deducting related expenses against their rental income. These expenses include, but are not limited to:
- Legal and accounting fees
- Property management fees
- Repairs & maintenance
The key expense that makes rental real estate tax advantaged is depreciation. Depreciation is a non-cash (aka phantom expense) that reduces the taxable income from your rental property, but not the cash generated. So in other words the cash is still in your pocket (or bank account), but you are not taxed on it.
In many cases the depreciation expense is large enough to create a net loss, and when a property shows a loss, there is no income and therefore no taxes.
Now isn't it great that we may not have to pay taxes on our rental income? This is what is often meant when someone says real estate is tax advantaged income.
The question is now, how is the loss treated? Can losses lower my taxes?
For Part-Time and Passive Real Estate Investors
An important concept to understand is income from rental real estate is considered passive income for tax purposes. Whereas active income from a business or job is considered ordinary income.
For the most part, part-time and passive investors cannot use passive losses from rental real estate to offset ordinary income. They can only deduct passive losses against passive income. However, there are a few exceptions.
Passive Loss Limitations
Taxpayers whose adjusted gross income (AGI) is under $100,000 can deduct up to $25,000 of passive losses against their ordinary income. This phases out $1 for every $2 of AGI above $100,000 until $150,000 then deduction is completely eliminated.
A taxpayer has an AGI of $90,000 and passive losses from rental real estate of $26,000. Because their AGI is below $100,000 they can deduct $25,000 against their ordinary income.
Now lets say the same taxpayer's AGI is $125,000, They can only deduct $12,500 against their ordinary income. (($125,000 - $100,000)/2).
If the same taxpayers AGI was $150,000, they cannot deduct any losses against their ordinary income.
Suspended Passive Losses.
Passive losses that are not deducted against passive income or against ordinary income as mentioned above are suspended and carried forward indefinitely until there is passive income to absorb the losses or the activity is disposed (i.e. rental property is sold).
If there are still suspended passive losses at the time the activity is disposed, then these losses will be deducted against income in this order:
- 1. Any gain from the sale of the disposed activity.
- 2. Income from other passive activity.
- 3. Ordinary (active) income.
As you can see part-time and passive investors may still be able to deduct suspended passive losses against ordinary income upon sale if the suspended losses are large enough.
Passive Investors who invest in large multifamily or commercial properties via syndicates may experience these large losses due to cost segregation and bonus depreciation.
For Full-Time Real Estate Investors
Investors who work full-time in a real estate trade or business can deduct the passive losses from rental real estate against their ordinary income if they qualify and elect to be treated a "Real Estate Professional" for tax purposes.
To qualify as a Real Estate Professional for tax purposes the taxpayer must meet the following criteria:
- Work 750+ hours in a real estate trade or business; and
- More than half of your annual working hours must be in that real estate trade or business
And in order for the rental activity to qualify as non-passive (aka active) the taxpayer must have materially participated in the activity.
The Real Estate Professional status is what really allows real estate investors to lower their overall tax liability, and pay less tax.
For this reason, this status is highly sought after by investors, but is nearly impossible to achieve if you have a full-time job or run a non-real estate business on a full-time basis due to the requirement that more than half your working hours must be in a real estate trade or business.
However, if a spouse does not work full-time, he or she may be able to claim this status which will cause both spouses to be treated a Real Estate Professional for tax purposes.
I hope that this blog post clarifies the tax benefits of real estate investing and eliminates much of the confusion and misunderstandings around the topic.
As for the many successful professionals and business owners in high tax brackets, I know you may be disappointed to find you cannot reduce your overall taxable income and liability as much as you hoped, but I encourage you not to simply write real estate investing off.
Rental real estate is still tax advantaged and you may end up paying little to no taxes on that income (assuming you are doing everything right), which is a lot better than the large amount of tax your paying on the income from your job or business. Not to mention all the other non-tax related benefits to consider.