HELP: Tax-Write-offs or limiting losses w/ high day job income?

16 Replies

Hi everyone, 

I need some tax and legal advice in my situation where I have been incurring a good amount of unexpected expenses, and after some research tax rules seem to allow up to $25K of write-offs a year, but is phased out all together when your AGI exceeds $150K if you are a passive investor.

Background:

I bought what I thought was a great cash flowing 4-unit multifamily property earlier in the year full occupied which was great for a few months.  Then I ran into a number of tenant issues, criminal activity in my units, vacancies, and maintenance expenses which leads me to a never ending nightmare of costs lately with very little rent.  I could sell the property and get out, but I see long term potential after I turn it around and want to keep it for now.

I foresee about $20K in net losses this year, and make over $150K annually in my day job. Although I know my salary is great and way above the national average, I am by no means rich, especially located in California's SF Bay Area where cost of living is probably #1 in the country and I've got 3 kids to support :-).  I have a property manager, and am considered a passive investor, so looks like I can't write-off anything which hurts pretty bad for my family this year.

The only thought that I have (and I am not sure how possible or legal this is) is that my spouse makes $70K/year, although we are NOT married and separate our finances in a way that we actually file single every year.  I bought this rental property solely in my name earlier this year, but I wonder if there is a mechanism or possibility that I can add her to title /owner or even fully transfer to her (which I do not mind) and leverage her lower income that qualifies for tax write-offs to help me with these expenses this year?  I'm sure there are tax and legal implications with ownership, her level of participation, etc. that need to be considered that I am not sure of based on the scenario/situation/result that I want.

Of course, I should consult a tax and legal professional for my specific situation, but I wonder if anyone here on this forum can directionally give me some guidance on any possibility in my situation here, so then I have a foundation and basic background to pursue.  Also, if there is a chance here, and I can add my spouse to title or fully transfer now before the end of 2015, can she take advantage retroactively of expenses incurred earlier in the year before she was officially part of the ownership for the tax year?

Thank you in advance for the help!

-John

I'm not a CPA or attorney, and you need to consult a CPA.

Don't bother trying anything tricky.  The "tax benefits" of money losing real estate are far overstated. 

Even though you cannot apply the passive losses to offset any of your ordinary income, you can carry forward those losses.  When you sell, you can apply those carry forward losses to reduce the gain on the sale.  Not just the property that generated them, but any rental.  Further, when you (hopefully) have money making years in the future, you will be able to apply those losses to reduce the tax on your rental income in the future.

In many cases, depreciation generates a part of your passive loss.  That's a two edge sword, and sellers of crummy rentals often only mention one edge.  That is that the depreciation deduction reduces your income on the rental, possible creating a passive loss you might be able to use to offset ordinary income.  But, as you've found out, there are limitations.   The other edge is that the depreciation deduction decreases your basis.  When you sell, the gain is the net selling price less your basis.  Not the net price you paid.   So, while the depreciation deduction might help in the short term, when you sell, it come back to bite you in the form of increased gains.

Further, when you sell, the amount of gain up to the amount of depreciation taken or allowed (whichever is greater) is subject to a tax on unrecaptured depreciation.  That tax is at your ordinary income rate, though it is currently capped at 25%.  Any remaining gain is taxed as capital gains.  That's the other edge of the depreciation sword.

So, if you are able to use the passive losses generated by depreciation to offset ordinary income, you will end up paying back those tax savings when you sell.  That's not the worst thing because you're essentially getting a loan from the US Treasury.  OTOH, if you cannot use them, and they carry forward, they help you when you sell.

@John Anderson , thank you for posting this. On the surface of it, it looks like you may indeed have fallen into some "Tax Traps" that would do well for other high-income Investors to watch out for. On my brief research, it looks like the moment one earns more than $150k per year, there is NO tax break for Real Estate losses in that year. But if one earned less than $100k, they could claim up to $25k in deductions off those same losses.

I hope you do find an Accountant who can help...

Oh, I just saw the post by @Jon Holdman. That certainly looks promising!

@Jon Holdman claims not to be a CPA, but he understands these transactions as well as one and it explains it perfectly and has given you great general information.

I would suggest talking to a real estate savvy CPA in a one on one consultation to discuss your particular situation.  There are solutions that could work for you, but I'd hesitate to recommend any of them without knowing a whole lot more.

Most CPAs will want to do a full on tax projection for both you and your spouse to understand exactly where you are before making recommendations.  A knowledgeable CPA may have strategies to lower your income overall, making transfers to your spouse unnecessary.  

I would keep track and carry over my losses to a more favorable year that can offset a gain you have.  Hopefully the property will be profitable soon, right?

 I wouldn't get 'sophisticated' and transfer assets to a spouse I'm not married to (?) 

The transfer could be a whole new gift tax no-no.   When the property is profitable, you'll get it back.  Just have to be a little patient.    

No legal or tax advice, just a nobody's opinion lol!  

@Brent Coombs the person who can deduct those passive losses ends up paying back the tax, or at least a significant chunk of it, when they sell.  The person who cannot deduct them gets a reduced tax burden when they sell.  Its not quite a wash, but its not far from it.  You're falling into the trap set by sellers of junk rentals and only considering one edge of this sword.

There is another way to get the passive loss deduction, but its nearly impossible for a small time landlord.  That is to be a real estate professional.  That's an IRS term that has nothing to do with licensing.  To be a RE professional, you need to spend at least 750 hours a year on real estate related activities AND spend more time on that than anything else.  So, if you have a full time job (2080 hours a years), the threshold becomes 2081 hours a year.

My general advice is to find a good accountant (CPA or enrolled agent) who's knowledgable about real estate and evaluate your situation and advises you on how to organize your finances BEFORE you start investing in real estate.  If you're not done that yet, @John Anderson , you really want to find one now.  Real estate investing and DIY turbotax tax preparation don't go together.  You can probably file an acceptable (the the IRS) return with turbotax and RE investments.  But you will very likely leave money on the table.  A good accountant will pay for themselves.

Agree completely with @Jon Holdman comments.  

Check out Stephen Fishman's "Every Landlord's Tax Deduction Guide" for a in-depth explanation.  

One way to overcome the phase-out of the deduction is to become a "real estate professional".  The IRS imposes very strict definitions on this (minimum total number of hours per year you work on real estate related activities, as well as more than 50% of your total combined work hours have to be devoted to real estate, etc).  So this is very hard to achieve if you hold a full-time regular job.  Nevertheless, if you do qualify, the phase-out as well as the 25k limit will disappear.

For most "mortals" its likely best to bite the bullet now and use the accrued deductions in the future, as detailed by Jon.

Updated almost 6 years ago

What Jon said!!! I didn't see his 2nd post until after I posted.... sorry about the duplication

Eventhough I'm a CPA, I can't give a definite answer to your questions since the passive income loss deduction of $25000 has so many exceptions. I will quote one here which may apply to you:

Married persons filing MFS (Married Filling Separate) who lived together at any time during the year cannot claim this allowance. Married persons filing separate returns who lived apart at all times during the year are each allowed a $12,500 maximum special allowance for losses from passive real estate activities.

My suggestion is to contact a qualified tax consultant who deals with Real Estates.

Good Luck.

@Jon Holdman , yeah, I had seen that 750 hr thing but didn't think that @John Anderson would be bothered with that (my guess was his actual job would not really leave that much time left, if he also wants a life). [Not sure what trap you think I'm falling into; I was just pointing out that the "one edge of this sword" that John wrote about was worthy of finding out if it was avoidable]. Cheers...

@John Anderson one additional point to all of the advice you have received, I would HIGHLY suggest you go talk to the tax assessors office before you do any changing of title. One of the major benefits of CA REI is prop 13. I believe that if you transfer title you might trigger a re-assessment of your property. I realize that you just bought the place this year, so it might not be a big deal, but I thought I would throw it out there for you to consider.

One thing that wasn't mentioned in this thread is that you can do an exchange instead of selling to avoid recapture of depreciation.  That is what many wealthy investors do.  If you set things up correctly your basis gets stepped up when you die and thus you never end up paying any of these taxes.  

You shouldn't buy a property simply for depreciation tax shields though.  That should be a nice, ancillary benefit that is coupled with a project that generates at least break even (or hopefully positive) cash flow and has the opportunity for nice appreciation.  If you leverage the property you'll also gain wealth monthly through amortization of the loan if you use fully-amortizing product.  

Tax situations can get extremely complicated and the only way you'll get quality advice is to post everything about your personal situation and have someone do a case study.  One thing that has worked for my wife and I is for her to remain passive in the entity that generates "active" profits in our real estate business.  Since she owns a portion of the entity and is passive then that portion of the profits can offset with passive losses.  That may be something worth considering if it applies to you.  

@all -- sorry for the late reply.. Been side tracked all week and finally had a chance to log back into BP.  THANK YOU so much for the fantastic insight, you gave me a lot to think about.  It's certain that if I want to get more serious and to evaluate my situation specifically that I need to get the help of a pro.  I appreciate you all giving me direction!

Originally posted by @Brent Coombs :

@John Anderson , thank you for posting this. On the surface of it, it looks like you may indeed have fallen into some "Tax Traps" that would do well for other high-income Investors to watch out for. On my brief research, it looks like the moment one earns more than $150k per year, there is NO tax break for Real Estate losses in that year. But if one earned less than $100k, they could claim up to $25k in deductions off those same losses.

I hope you do find an Accountant who can help...

Oh, I just saw the post by @Jon Holdman. That certainly looks promising!

 Is that true if you are not a passive, but an active, investor?

@Andrey Y. , to the best of my knowledge, the Tax people do not make a distinction between "active" or "passive" Real Estate Investors, except how they define "RE Professionals". As @Jon Holdman recorded, they would be the ones who "spend at least 750 hours a year on real estate related activities AND spend more time on that than anything else". [Not official tax advice]. Cheers...

@Andrey Y. , oh, I just saw on another thread where someone mentioned that you don't pay self-employment tax on passive income. Is that what you were alluding to?

"The IRS defines just two types of passive activity:

  • trade or business activities in which you do not materially participate during the year; and
  • rental activities, even if you materially participate in them, unless you are a real estate professional.

It would be highly unusual for a person to meet the first definition: Own an SMLLC engaged in trade or business yet not materially participate in those activities.

The second type of passive activity defined by the IRS, however, is often relevant. Many people use SMLLCs in connection with rental property they own. If you’ve set up an SMLLC for this purpose, you won’t need to pay self-employment tax on your rental income. You will, however, need to report any income (or loss) from your rental property using IRS Schedule E, Supplemental Income or Loss. The information on Schedule E ultimately gets carried over to your Form 1040 and is factored into your overall income tax liability". [Not tax advice].

I'm still learning too. Cheers...

@John Anderson it appears John that you are being given some sound advice here but the bigger question I would ask is why did you not seek professional advice before you bought the property? If you had sought out professional investment advice in regards to the effects of taxation on your investment from a suitably qualified CPA then you would probably not be having this problem.

I hope other investors who read this thread appreciate the complexity the taxation implications can be on an investment and seek independent advice before purchasing/investing. Saving a few dollars by not seeking advice before investing can prove to cost lots more when things are not done correctly.

Good luck with your project and happy investing!