Offsetting Income with Passive Paper Losses

We usually preach how you will receive significant paper losses in the first year of an investment with us to offset other passive income. Those losses come from accelerated depreciation. This article will dig into four ways you can use those paper losses to offset other income. We will also discuss what can be done with those losses.

Four Ways to Offset Income with Real Estate Passive Losses

1. Are you a Real Estate Professional?

Being a real estate professional is the most powerful way to use this passive loss to offset any income.

The IRS defines a real estate professional as:

1.) “More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.”

2.) “You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.”

The above definition means that you essentially need to be active in real estate activities at least 15 hours per week. As you can see, the barrier to entry as a real estate professional is high. You can also get creative; for example, doing bookkeeping for real estate ventures could count. It could also be your spouse involved as a real estate professional, and then it could count for both of you.

Here at JB2, as real estate professionals, we essentially never need to pay income tax because paper losses offset all of our income while still making a profit. Ultimately hitting this threshold could be possible if you are working a flexible remote job that allows you to fit in real estate hours. It’s something to consider if you will be regularly investing in real estate.

2. Offsetting Other Passive Income

Many times, investors use these passive losses to offset income from other properties they are invested in. So ideally, you invest in at least one real estate deal a year to continue to use the paper losses.

You can also use these losses to offset other passive business income you do not materially participate in. If not a real estate professional, these losses usually cannot be used to offset capital gains and dividend income. The good thing is your carry these losses forward for 20 years, in which time you will find passive income to offset.

3. Opportunity Zones

Another form of investment that has gained popularity in the last few years is investing in properties in Opportunity Zones. For investors that are approaching huge capital events, this can be a potent tax reduction tool.

What is a Qualified Opportunity Zone?

“A QOZ (Qualified Opportunity Zone) is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as QOZs if they have been nominated for that designation by a state, the District of Columbia, or a U.S. territory and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service (IRS).”-IRS website

The two main benefits of investing in properties in opportunity zones are tax deferral/reduction of investment gains and elimination of all capital gains tax liability from future value appreciation.

Major Benefits of a QOZ

Capital Gain Reinvested into OZ Property:

• Temporary deferral for up to nine years
• 10% reduction in tax on the gain if a property is held for at least five years
• Additional 5% reduction in tax on the gain if held for at least seven years total
• The reduced tax will need to be paid on the initial capital gains invested within these nine years.

Future Capital Gains Accrued While in OZ Property:

• If held for at least ten years, gains in this particular property if sold are excluded from tax.

The OZ property does have a couple of significant downsides. For example, within 30 months that property needs to be substantially improved to double its adjusted tax basis. This means that you need to invest in a deal that needs significant work to receive the passive loss benefit. Secondly, these opportunity zones are usually in low-income areas and may not be areas you want to invest in. This isn’t, of course, always necessarily true. In the case of JB2, we wouldn’t invest in a deal just for opportunity zone incentives, though it may allow us to be a little more aggressive on pricing while still being mindful of our standard requirements for investment.

Of course, there are other stipulations and fine print regarding these incentives that you would need to investigate yourself to confirm. Our goal here is to provide you with some high-level guidance for thought. This can be a powerful tool for someone who needs to shelter huge gains, but it’s a lot easier said than done at the end of the day.

4. Active-Participant in Rental Property

Suppose you are an active participant in your rental properties. You may be able to deduct up to $25,000 in rental losses from ordinary income.

Active-Participant examples:

• Approved repairs or capital expenditures
• Found and approved tenants yourself

You must have an adjusted gross income (MAGI) of $100,000 or less to deduct the $25,000. If you are below 150k (MAGI), you can deduct some. You cannot deduct the losses against ordinary income if you are above the income threshold unless you are a real estate professional.

One Rule That Can Limit Deductible Losses

These are at-risk rules laid out by the IRS. You may be limited to losses in the amount invested in a deal. For example, if you invested $50,000, you can only deduct $50,000 in losses for that given year. Don’t forget you can always carry losses forward for 20 years.

Bringing it Together

What we shared above can be effective tax-saving mechanisms. Though we always look at these incentives as icing on the cake and focus more on returns over these benefits, being a real estate professional gives you the most flexibility to take advantage of these bonuses. If you have some impressive gains to shelter a well-placed opportunity zone property, it could be interesting.

We always keep an eye out to see if the properties we are looking at land in these zones if it’s a strategy we can take advantage of. Please always consult your CPA and other advisors to confirm anything we have discussed before making any significant investment decisions.

for educational purposes, all strategies discussed need to be reviewed with your tax professional.