The tax benefits of bonus depreciation can lead to massive savings but losses won’t help one bit if you can’t use them.
Before you buy a cost seg, you need to know the rules:
Tax all starts with the types of income.
1. Active = Income earned from Material Participation.
Whether that's SMB, W-2, contract income, or prof real estate.
This is income where ordinary tax is paid and losses offset other income.
Other sources have certain loss limitations.
2. Portfolio = Income derived from financial instruments like dividends (including REITs), interest, royalties, and capital gains.
Mostly income w/out loss potential, and favorable tax rates.
Cap losses may offset cap gains w up to $3,000 loss. Investment interest can be deductible.
3. Passive income which sec 469 defines as:
1. Income from a trade or business where a taxpayer doesn’t materially participate.
2. Rental activity.
Passive losses may only offset passive income, not active or portfolio.
This is a problem for wage-earning real estate investors.
So HOW DO I GET THOSE DEDUCTIONS?
Become a Material Participant.
We are given a clear framework for determining Material Participation (not passive) in Pub 925.
There are 7 scenarios that will get you there.
Material participation scenarios (Pub 925):
1. 500 hours.
2. Substantially all participation.
3. More than 100 hours and 1/2 of your time.
4. Significant participation.
5. You materially participated in the activity for any 5 of the last 10 tax years.
6. Personal service activity w participation in last 3 years.
7. Continuous participation.
This is great if you are talking about an SMB with effectively connected Real Estate.
Note rental activity is considered passive unless you meet the RE Pro threshold of 750 hours and more than 1/2 your time.
This is the conundrum for passive real estate investors.
If you have a full-time job or a large, time-consuming business it can be difficult or impossible to qualify.
A huge loss from depreciation if you have one LP investment isn’t going to do anything for you.
You won’t be able to deduct it.
So what to do?
A few ideas:
1. Acquire enough RE that it takes you or your spouse more than 750 hours a year and 1/2 of your time to manage.
When you are a material participating RE pro all of your and your spouses’ RE activity becomes active, allowing you to offset RE losses against other active income.
One pitfall of a RE Pro spouse if you are full-time W-2.
Mind Excess Business Loss Rules.
You can only offset W-2 income with $610K in 2024.
For single filers, the limit is $305K.
2. Run an Opco/Propco model.
If your business utilizes real estate as part of ongoing operations you can get all the tax benefits of active RE by having the building purchase and hold the RE.
3. Build an SMB on top of your real estate (the reverse of #2)
Short-term rentals and high owner-participation real estate businesses can have great returns.
Obviously not for you if you just want passive RE.
We are in the deep end here, where each case should be judged on its own facts and merits by your CPA.
You should hire a professional to review your particular situation before you make an investment. It is worth it to know where you stand.
