Passive Income Tax Status for New Construction?

Question

I have been in talks with a GC in Georgia and his method of building is: He builds everything at costs and doesn't include any markup or fees, he oversees everything, I only supply funding, and we split 50/50 the profits after paying back the bank and all other associated fees.

Since I am only supplying the funding for the deal, is there a way I can structure doing this so that this is considered passive income for myself since I won't be involved with the construction or overseeing the project? I have some rentals and have more depreciation than what they rent for so if I was able to classify the new construction as passive income, I could then use the "losses" from my other passive investments to help offset the income. For additional reference, I live in TN. Married, both W2 earners at 225k combined. I fully plan on 1031-ing every property I ever own as a rental, so I'm not concerned regarding depreciation recapture.

Kory Reynolds · Answer

As long as you are not a "material participant" in the activity, then it will be considered Passive. To do that, as long as you don't hit any of the standard tests (just google "material participation tests" to find the 7 tests), you are passive, and you can offset that income with your other passive losses.

It will all come down to the nature of your involvement. If you are truly just writing a funding check, and collecting a check at the end, most likely you'll be considered Passive.

It will all come down to the nature of your involvement.  If you are truly just writing a funding check, and collecting a check at the end, most likely you'll be considered Passive.

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Account Closed · Answer

Your head is in the right place. You should be considered passive here since your not "materially participating" which is a great strategy for building wealth. Some of our clients even find ways to get the businesses they own to be considered passive and thus taxed as such. It all comes down to participation.

Michael Plaks · Answer

@John Michael Roberson

I agree with @Kory Reynolds: tax-wise, it is a workable plan, as long as you are hands-off, which in technical terms is known as failing material participation.

I would caution however against focusing strictly on taxes. If you enter a true partnership with this GC, you will be splitting not only potential profits but also potential losses. There is no guarantee whatsoever that this project will produce profit. And the GC has no money at stake, so he can simply walk away if things go badly, leaving you holding the bag.

If, instead of a partnership, you take the role of a lender, your money will be safer. However you will give up potential upside if the project goes well. Which option is the best route business-wise is a complex decision. Taxes are only a part of this decision.

Passive Income Tax Status for New Construction?

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