Passive Losses, NIIT, and CRE Syndication

2 Replies

Hi Bigger Pockets,

I've seen bits and pieces of information about this in various places, but I'd like to ask people who have actually gone through this procedure.

I anticipate my rental properties will accumulate about 10k in passive losses per year for the next few years (courtesy of of the 27.5 year depreciation schedule -- not due to pre-tax negative cash flow). I'm above the passive loss threshold and subject to the net investment income tax (and I'm in a high tax city). I'm single and don't anticipate marrying a real estate professional any time soon, so those losses are locked up.


Questions:
1) Regarding Net Investment Income Tax... Do my passive losses on the properties offset the stock dividends and bond interest from other portfolios -- such that I can report no net investment income and thus avoid the NII tax? I realize I will still have to pay income tax on the bond interest and long term rates on the dividends, but my understanding is that I can dodge the NIIT surcharge if the bond interest + dividends + rental passive loss is negative. Is my understanding correct?

2) Can I offset the passive losses with an investment in a syndication like what they offer in CrowdStreet? Assuming I am correct about question 1, I would not want to offset all of the losses, just enough to keep my NII close to zero.

3) It seems to me that passive losses are "wasted" if I 1031 exchange the property. Sure, I lowered the taxable appreciation on sale, but that seems to be pointless if I won't pay taxes on the appreciation anyway.

Overall, my strategy would be to balance my investments such that my NII from all my investments is close to zero on an ongoing yearly basis (I realize this is optimistic, but I can at least try to get close). If it comes time to sell a physical property, I want to have accumulated as little passive loss as possible to avoid trapping the loss in a 1031 exchange.

To give a concrete example, if I buy a 200,000 house with a land value of 40,000, I depreciate 5,818 per year (assume cash flow is small due to buying the house with a mortgage). If I have a syndication that effectively throws off 5,000 per year, and my portfolio (stocks + bonds) income is 818, my net investment income is 0 so I pay no NIIT. Effectively, I have tax-free cash flow from the syndications and tax-free appreciation from the physical properties (if I 1031 exchange them before the 27.5 years is up and donate/bequeath them in my will). Also, I wouldn't be paying the extra 3.8% on the investment income -- or at least not too much of it. Over time, I would want to keep these ratios while scaling up to minimize taxes.

(I realize I cannot control the outcome of investments with that level of precision, but I'm using those numbers to illustrate a point).

Feed back would be much appreciated! Thanks!

@Jeffrey Scholz

I will answer 1 of your 3 questions.

Yes, investing in a passive investment that generates passive income like a CrowdStreet fund can offset passive losses. Make sure the income is indeed rental income and not other income such as interested. Positive passive rental income will offset passive rental losses.

As for the other 2 questions, consult with your CPA. I don’t like to give out advice for free.

Originally posted by @Jeffrey Scholz :

Hi Bigger Pockets,

I've seen bits and pieces of information about this in various places, but I'd like to ask people who have actually gone through this procedure.

I anticipate my rental properties will accumulate about 10k in passive losses per year for the next few years (courtesy of of the 27.5 year depreciation schedule -- not due to pre-tax negative cash flow). I'm above the passive loss threshold and subject to the net investment income tax (and I'm in a high tax city). I'm single and don't anticipate marrying a real estate professional any time soon, so those losses are locked up.


Questions:
1) Regarding Net Investment Income Tax... Do my passive losses on the properties offset the stock dividends and bond interest from other portfolios -- such that I can report no net investment income and thus avoid the NII tax? I realize I will still have to pay income tax on the bond interest and long term rates on the dividends, but my understanding is that I can dodge the NIIT surcharge if the bond interest + dividends + rental passive loss is negative. Is my understanding correct?

2) Can I offset the passive losses with an investment in a syndication like what they offer in CrowdStreet? Assuming I am correct about question 1, I would not want to offset all of the losses, just enough to keep my NII close to zero.

3) It seems to me that passive losses are "wasted" if I 1031 exchange the property. Sure, I lowered the taxable appreciation on sale, but that seems to be pointless if I won't pay taxes on the appreciation anyway.

Overall, my strategy would be to balance my investments such that my NII from all my investments is close to zero on an ongoing yearly basis (I realize this is optimistic, but I can at least try to get close). If it comes time to sell a physical property, I want to have accumulated as little passive loss as possible to avoid trapping the loss in a 1031 exchange.

To give a concrete example, if I buy a 200,000 house with a land value of 40,000, I depreciate 5,818 per year (assume cash flow is small due to buying the house with a mortgage). If I have a syndication that effectively throws off 5,000 per year, and my portfolio (stocks + bonds) income is 818, my net investment income is 0 so I pay no NIIT. Effectively, I have tax-free cash flow from the syndications and tax-free appreciation from the physical properties (if I 1031 exchange them before the 27.5 years is up and donate/bequeath them in my will). Also, I wouldn't be paying the extra 3.8% on the investment income -- or at least not too much of it. Over time, I would want to keep these ratios while scaling up to minimize taxes.

(I realize I cannot control the outcome of investments with that level of precision, but I'm using those numbers to illustrate a point).

Feed back would be much appreciated! Thanks!

1 and 2)  Yes, rentals loss can negate your NII but only if rentals do not rise to non-passive- trade or business. It might rise to the level of non-passive trade or Business If you qualify as RE pro or meet any of the rental exceptions. 

3) Provided the requirements for a like-kind exchange are met, the suspended passive losses are carried over into the replacement property, and the income generated from the replacement property can be used to offset those suspended passive losses.

One way to tap into the suspended losses of Like kind exchanged property and also defer the capital gain:  

  • Structure an exchange to recognize again to the extent of the suspended loss. So if the gain is recognized because of receiving a boot, it is treated as passive income that can offset your suspended loss. So for Like-kind exchange, it is better to get the boot to suspend the passive loss of the given up property or just, in general, to generate passive income if you have other passive losses that are not deductible.