Passive losses advantageous for Roth conversion?

Question

Hello

i have a traditional 401k from old employer it has little over 100k, I would like to move it to an SDIRA or Solo 401k to make some alternative investments. I also have some passive losses for this year due to a syndication investment I made this year, can I use this passive loss to my advantage to convert my traditional 401k to a Roth Solo 401k or Roth IRA with minimal to no tax hit? Appreciate your inputs.

Thanks

Brett Synicky · Answer

@Basit Siddiqi You are right.  In my haste I missed that key point.  I guess the decision is do I want to pay taxes on the seed or the harvest.  Thanks for the correction!

Brett Synicky · Answer

@Sateesh Kumar Personal investments are totally separate from an SDIRA or Solo 401k.  Rolling over your former employer 401k to an SDIRA or Solo 401k is not a taxable event as it's a direct rollover.  If you qualify for a Solo401k it has quite a few benefits over the SDIRA like the participant loan option and no UDFI on leveraged real estate for a couple examples.  Check with your CPA to be sure, these are two separate conversations.  Hope this helps.

Charles LeMaire · Answer

@Sateesh Kumar - I'm a passive investor, not a CPA, so take with a grain of salt. First the IRS divides income & losses into three buckets: earned, portfolio, and passive.  Normally for a non RE Pro, these buckets do not mix.  There is a low income $3K rule; I find most syndication investors are above that.   But it has been my experience that passive gains unlock passive losses and that at the complete disposition of an asset, accumulated losses are available to the non RE Pro to be used against all income.

So if you buy a property in the year you sell a property (especially when Bonus Depreciation is used) you get to use that passive loss against income, like the capital gains on the sold property, your W-2, or that conversion you are thinking about.  The benefit is that it can offset the income with the higher tax rate.  Realize this is kicking the can down the road; the basis of the purchased property goes down (and you get the associated depreciation), but when you sell that property,  the amount garnered will mostly be cap gain that you will need to pay tax on  -- or remain on the merry-go-round and buy another.  And there is a possibility that 100% B.D. will be restored. (I find this hard to believe as Pres Fair Share & Tax-the-Rich will have to sign it.  But who knows! )

The rule is in 26 US Code 469 paragraph G - but it is full of CPA speak.  Note RE Pros often aggregate properties to enhance getting to be an RE Pro.  This will obviate the complete disposition of an asset.  Also look for form 8582 in your taxes to see the aggregations of RE gains and losses.

Regards!

Michael Plaks · Answer

This is certainly a good disclaimer.  :)   Thank you for bringing up the important consequences of selling a property. However, in your attempt to serve a tasty dish, you threw some sushi and some ice cream into gumbo. All three are great dishes, but separately. 1. When you sell a property, you create "income from passive activity" (which, if you care about details, includes capital gains and depreciation recapture.) Let's say you created $100k of this income. You now created room to utilize $100k of passive losses. They could be unused ("suspended") losses from prior years, and they could even be losses from other properties or from syndications.2. When you sell a property, ALL unused/suspended losses attached to that particular property are unlocked. This happens regardless of how much room you have created by capital gains. Even if there was no capital gain at all, you still get to deduct all accumulated losses. In this case, they do offset your W2 income and any other non-real-estate income, including Roth conversion. Notice that we're talking about losses for one property only, the one being sold.3. If instead of selling outright, you exchange your property for some other real estate, known as a 1031 exchange - then you do not have capital gains and you do not create any room for passive losses as in #1 above. And then (and only then!) do you kick the tax can down the road as described by Charles. By the way, the unlocking described in #2 above still happens.4. Aggregation of properties that Charles mentioned does NOT create the negative side effects that he alluded to, but this is too technical to discuss here.

5. Bonus depreciation mentioned by Charles is kind of separate from everything mentioned in my post here. It has complex interplay with various other pieces of the puzzle. For example, if you have a large capital gain from the property sold, you possibly open enough room for additional losses on other properties, such as a new property you're purchasing in the same year. And then cost segregation and bonus depreciation can be helpful. Again, this gets real complicated real quick.

PS. Regardless of the still unsigned new law, bonus depreciation is alive. The issue is whether it stays at 100% as it was in 2022 or drops to 80% for 2023 and 60% for 2024 as it is supposed to do under the law currently in effect.

Basit Siddiqi · Answer

The OP was talking about Roth ConversionsConverting from a Traditional Retirement Account to a Roth Account is a taxable event.But you are right, most rollovers from a traditional to a traditional, or Roth to another Roth Account are not considered taxable events.

Charles LeMaire · Answer

@Michael Plaks  - It seems we agree, but I may have to learn to say things more accurately.  Thanks for the clarifications.

Charles LeMaire · Answer

@Michael Plaks - Thanks for the compliment (and the cooking lesson)... :)

For my clarification and perhaps others (there have been a couple vote, for what it worth), allow me to hit your point one by one.

#2. I am under the impression that the losses that are unlocked are from that property AND all property that year. Saw a suggestion to bunch repairs to take advantage of this.

#3. When I say kick the taxes down the road, I view CS & BD as a mini 1031 in effect (not law).  My $100K investment is returned at a sale with $100K gain.  I invest $100K in a new investment, get $90K depreciation, so I pay tax on $10K.  The $90K gain shows when the second investment sells and the basis is not restored as the depreciation was already used.  Of course, I stay on the merry go round and do it again, but it works a lot easier with CS & BD.  It seems to have the same tax effect.

As an asside, as I passively invest in MF syndications, 1031 are technically possible, but unlikely.  I have seen two happen.  It is just hard to heard the investor (cats) in to the next deal.

#4. As I discussed this in my journey, it was explained that GPs who are in non-active rolls in a deal, will "aggregate" to enhance their RE Pro status.  But when this is done, it ties all there deals together, the effect of which is that at a sale of one, it is not consider complete disposition.  You know, everything on the internet is the truth...

#5. Perhaps I am naïve, but CS & BD understandable, though I will admit it is the topic at meeting after meeting, so someone thinks it is hard. And I invest mostly in built buildings and know the new build rules are a bit different.  CS:  Dirt does not depreciate.  Take building, divide into property types (5 year, 15 year, and 27/39 year), then recalculate the depreciation.  BD: Pull all the 5 year & 15 year to day one.  Note CS must be done by engineers - there is a cost.  At this point in a syndication, the RE Pro are taking the resulting total off their income (of spouses income).  But we non-RE Pros have to sold something or it goes in the bucket for later.

So Michael, smack me around, I think it is better for all to have a good understanding.

Regards,

Passive losses advantageous for Roth conversion?

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