The PIGs of Real Estate

When you hear the word “pig”, you may be thinking of an animal that is associated with filth, mud or dirt. When people use the term “pig” in a derogatory way about someone, they typically refer to that person as being very messy. Ironically, pigs or swine as they are also called are actually known to be very clean and highly intelligent.

And the latter description quite well represents my following point – that PIGs are quite smart!

We will be using the term PIGs to refer to Passive Income Generators. Simply put, PIGs represent the type of activities that qualify as passive income that is generated without any day-to-day interruption and in which there is no direct and material involvement.

The lack of material participation typically exists in such activities as real estate and rentals.

Therefore, any business activity where you do not materially participate, is considered passive.

You can typically offset this passive income against passive activity losses. Generating passive losses will in turn allow you to lower your tax liability. Basically, you would only be responsible to pay the taxes on the difference between passive activity income and passive activity losses.

Just like passive income, passive losses are also produced through passive activities. Passive losses are actually relatively easy to generate. For example, let’s assume you are generating income from an investment rental property. At the same time, this investment property depreciates in value and therefore creates “paper” losses.

One would think that these losses are bad, but in reality, these are so-called “paper” losses that allow you to lower your tax liability on your tax return.

But having passive losses are a gift that keeps on giving because when your passive losses are higher than passive income, you can carry forward these passive losses into future years to offset upcoming passive income.

For example, let’s say you bought a PIG – an investment rental property that will be depreciated over time, and hence this property will show as a loss on your tax return, at least in the first few years. However, in reality you’re renting it to tenants that are paying you monthly rental income, and this income is higher than your operating expenses. The result is that while on paper this rental property has higher losses than income, the reality is that your investment property bills are paid and it is even producing monthly income for you and your family.

Word to the wise – do not try to calculate taxes on the passive income yourself. Rather use a CPA or a qualified tax preparer. While there are a lot of activities that may qualify as PIGs, it is best left to experienced CPAs to decide what qualifies as such. For example, rental income from a single-family house or a condo that you bought and are renting out to tenants is considered passive unless you can claim real estate professional status.

Quite a lot goes into qualifying as a real estate professional. In order to qualify in any given year, more than half of your services in trades or businesses during the year has to be performed in real estate. You must have also participated materially in such business. In addition, you must have spent more than 750 hours in real estate activity where you materially participated. Material participation has its own set of rules and definitions, which we will not dive into to keep this article relatively simple. In short, if you have a W2 job, chances are very slim that you can claim a real estate professional status on your tax return. It is much easier to claim a real estate professional status on your tax return if you are a realtor, or have a part time job, and hence have the time to work on a real estate business as part of or in addition to your job.

A much simpler, but not a very common way to generate passive income is to invest in single asset syndications and/or funds. This income is passive both, on paper – the tax return, and in practice since your day-to-day operational involvement would be non-existent.

If you want to learn more about pros and cons of investing in syndications, take a look at this article. On the other hand, pros and cons of fund investing are explained very well in this article.

One last parting thought. This passive income offsetting strategy works really well for investors in higher tax brackets simply because it allows to offset passive income against passive losses and only pay taxes on the difference. That is why it is one of the strategies the wealthy utilize.