The Ultimate Strategy to Tap into Suspended Rental Passive Losses

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We all love real estate. Investing in rental properties is significantly better than the stock market with respect to returns and tax advantages. Not only can we leverage ourselves to the teeth and see beautiful returns, but our cash flow is usually tax free. That’s the beauty of real estate: the ability to grow wealth relatively tax-free.

Advice from your resident CPA: Use leverage wisely. “Leveraging yourself to the teeth” was a joke, kind of.

It always amazes me that investors analyze deals without ever considering the tax benefits. I want to shake them and yell, “Wake up, dude!” Investing in rentals, and real estate in general, provides significant tax advantages. Why wouldn’t you include them in your analysis?!

For instance, let’s say you are cash flowing $200 per month, but you also have depreciation in the amount of $500 per month. Not only is your $200 monthly cash flow going to come out tax-free, but you’ll have $300 per month in depreciation, or $3,600 annually, that will offset your ordinary income. If you’re in the 28% tax bracket, that’s an additional $1,008 of tax savings that you wouldn’t have had unless you were investing in real estate. That number needs to be a part of your analysis!

By the way, cash flow and net taxable income are rarely the same thing, but for the example above, just go with it.

The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. So what happens when you can’t take advantage of the passive losses because your income is too high?

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Phase Out of Passive Losses

When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually. Oh, you’re MAGI is really just your Adjusted Gross Income (AGI) on steroids. But for purposes of our discussion, you can refer to your AGI for simplicity.

As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.

This poses a problem for high income taxpayers, especially when MAGI is above $150,000. High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional. While I love pushing the real estate professional qualification onto my clients, it’s rare that a taxpayer will qualify unless they give up their day job.

Related: 7 Myths About the Real Estate Professional Tax Status, Debunked

What Happens to the Passive Losses We Can’t Use?

When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.

The good news is that you don’t “lose” your passive losses generated from your real estate rental. The bad news is that you can’t use your passive losses today. Personally, I’d rather benefit from those losses today and increase my working capital, through tax savings, to invest for tomorrow. Additionally, if I can’t use my passive losses today, I essentially have a portion of my return on investment (ROI) tied up in the clouds. Not cool.

I have had a number of investors come to me over the past few years who are experiencing problems associated with suspended passive losses. Some of these investors have as much as several hundred thousand dollars of passive losses suspended and being carried forward into future years. This is not good. We want to use those passive losses to see significant tax savings and build tax-free wealth.

Imagine that you have accumulated $100,000 in suspended passive losses over the years. If you’re in the 28% tax bracket, that’s $28,000 you’re leaving on the table. Imagine what you can do with $28,000. If you could have used these passive losses, I bet your ROI on those rentals you own would look a lot better!

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Strategy #1 to Tap Into Passive Losses: Buy Cash Flowing Rentals

The first strategy to tap into your passive losses is to buy better performing real estate. You may notice that real estate in a prime appreciation market will produce significant passive losses each and every year. Investing in such real estate will be great for wealth building, but not so great from a tax standpoint since you won’t be able to offset your ordinary income with the losses.

Instead, diversify your portfolio by investing in high cash flow, low appreciation markets. These markets can be scary because they are often secondary or tertiary markets. But with the property due diligence, you can usually squash your worries. Check out the article I wrote about analyzing an out-of-state market. All of these cities should have readily available financial and demographic statements that you can analyze as part of your due diligence.

The high cash flow properties will generally not generate passive losses. This occurs because the relationship between rent and price increases drastically in cash flow markets. For instance, in D.C., we often see a monthly rent-to-price ration of 0.5% to 0.9%, and the properties are going for $700,000. In tertiary markets, you may find a solid rental with a monthly rent-to-price ratio of 1.5% to 2% on properties worth $150,000. Without going into which investment is better or rekindling the whole “2% rule sucks” argument, the point I’m making is that the property generating monthly rent-to-price ratios of 1.5% to 2% will likely have net taxable income even after depreciation.

If this is the case, these properties can be used to tap into the suspended passive losses you are carrying forward. Passive income offsets passive losses without regard to what your MAGI is. So if you have significant passive losses, look into secondary and tertiary markets where the rental yield relative to price is much better.

It pains me to say this, but turnkey properties are a good example of high cash flowing rentals where the income can be used to offset passive losses. Be very careful with turnkey, though. Often, the benefits you receive today will be far outweighed by the costs you incur in the future.

Strategy #2 to Tap Into Passive Losses: Sell Your Rentals

Another great strategy to tap into your suspended passive losses is to strategically offload your rental properties. The cool thing here is that you don’t have to sell the rental property that has generated the losses, as the losses will offset any type of passive income.

When you sell a rental property at a gain, you must first determine what the gain is. The gain will be the net selling price less your adjusted basis in the property. Your adjusted basis is your original basis, less depreciation.

Once you determine your gain, you must determine how much of that gain amounts to depreciation recapture and how much of that gain is capital. It can take a lot of accounting work and cost a pretty penny.

Related: 3 Common Tax Strategy Myths Taught to Investors at Educational Seminars

But the great thing is that if you have passive losses, the passive losses can be used to offset the gain. This can equate to massive tax savings and is often a fantastic way to liquidate wealth for redistribution in a tax free manner.

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Strategy #3 (the Ultimate Strategy) to Tap Into Passive Losses: Invest in a Business

This is my favorite strategy, and few investors utilize it. The best way to tap into your real estate’s suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.

The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!

You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.

You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can’t invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.

Here’s why this strategy is so awesome. First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.

Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.

Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.

This strategy is phenomenal and certainly takes a few years to set up. But trust me, by year 10, you’ll be sipping cocktails on the beach and paying for everything with tax-free income.

Strategy #3.5 to Tap Into Passive Losses: Invest in your Family Member’s Business

To expand upon Strategy #3, if you are seeing your passive losses stack up year after year and your family member is running a business, ask them if you can invest with them for a certain stake of the business. You’ll have some level of trust and will likely already know what their work ethic is like, so your risk of total loss is likely reduced. Additionally, it’s relatively difficult to find small businesses who are actively seeking money partners, and those that are are likely seeking venture capitalists who are going to invest a boat load of money and bring experience to the table.

Would the business owner benefit from your funds? Heck yes.

As an example, I recently took a beach trip with my parents, and the topic of their suspended real estate passive losses came up. Because my business is now doing well and should continue to do so well into the future, I brought the idea up of having my parents invest in my business for an ownership stake. For the capital they’d give me, I’d provide them with a stake in the profits without giving them any sort of control or say so in how I operate.

The benefit for my parents is that the profits I provide them will be tax-free to them since they will be tapping into their passive losses. The profits I provide them will be a business write-off for me, saving me about 45% (federal tax, self-employment tax, state tax) on every dollar.

Additionally, I will now have upfront access to capital. I can then use this money to invest in my business, or I can loan/distribute it to myself and use it to invest in real estate. The latter will allow me to continue building my own portfolio and accelerate my tax-free wealth growth.

Related: Tax-Saving Strategies for Real Estate Investors: How to Pay Less & Keep More This Year

What’s really happening here is that I’m benefiting because the profits I’m providing to my parents are coming with a 45% discount (my tax savings), meaning that if I give them $10,000, my “out-of-pocket” is only $5,500 after taxes. On top of that, the $10,000 I give them is tax-free to them since they are offsetting this income with their passive losses. So we’ve turned $10,000 into $14,500. Additionally, I’ll likely use their capital to grow my real estate portfolio, and I’ll focus on building additional tax-free wealth. Best of all, we are keeping these savings and wealth building inside the family.

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Summary

Passive losses are amazing if used effectively. If you are seeing a high amount of passive losses being carried forward every year on your tax returns, partner up with a family member on a business opportunity. Be the passive investor and earn passive income. All the wealth that is generated will be kept inside the family, and you’ll have an untouchable empire that will be passed down for generations.

Get creative and never let your tax position get you down. We can always find ways to change your facts and help you tap into tax-free wealth.

How do you position your taxes to help build tax-free wealth? Any questions about the above strategies?

Be sure to leave a comment below!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

14 Comments

  1. William Handy

    Brandon, great article! Never considered a passive investment in a small business to offset losses.

    When you said the payments from you business back to your parents are tax deductible business expense for you, how do you structure the payments so they are a business tax deduction for you and considered passive for your parents? I’d think the payments back to your parents would be considered dividends making them non tax deductible expenses for your business.

    • Brandon Hall

      Thanks! When you invest in a partnership, LLC, or S-Corp, the payments that come back to you, while they may be called dividends, are really passed through to your tax return as regular “passive” income.

      A C-Corp is the only instance in which a “dividend” will be taxed at 15%. The C-Corp may or may not issue a dividend. If the C-Corp does not issue a dividend, you have nothing to report.

      S-Corp “dividends” are still passed through to your return and can be used to offset passive losses. Even if the S-Corp does not issue a dividend, you will still have taxable income passed through to you from the S-Corp.

  2. Craig Lessler

    Brandon,

    Can passive losses that are freed up by the sale of a property which exceed the depreciation recapture and capital gain resulting from the sale be used to offset ordinary income and W-2 income?

    Also, if you sell one rental property, do you free up the unused passive losses from the other rental properties to use to offset not only any depreciation recapture and gain, but also to offset ordinary income?

    • Brandon Hall

      Can passive losses that are freed up by the sale of a property which exceed the depreciation recapture and capital gain resulting from the sale be used to offset ordinary income and W-2 income?

      A: yes, as long as the sold property is not grouped with other properties and is considered its own passive activity.

      Also, if you sell one rental property, do you free up the unused passive losses from the other rental properties to use to offset not only any depreciation recapture and gain, but also to offset ordinary income?

      A: yes, the passive losses can be used to offset the gain from the sold property but excess passive losses, unless caused by the sold asset, will not offset ordinary income.

    • Brandon Hall

      Ben – same goes for the article you wrote as well!

      Regarding 3.5 – the key is control. I wouldn’t want anyone to invest in my business if I don’t have control. But if I can take $50k cash, invest in a real estate deal that funds the “profit share” to my family, then I get tax free income and THEY get tax free income. Beautiful.

  3. Christopher Throop

    Hi Brandon. Your recent posts about passive losses and related strategies have been really helpful to me and I have a much better understanding about the situation I found myself in a couple years ago.

    Can you elaborate on your comment regarding turnkey investments and explain what you see as the future costs that will outweigh the current benefits? Why are you so reluctant to recommend this strategy to tap into passive losses?

  4. Brandon Hall

    I don’t like turnkey for many reasons. Most notably:

    1. If the deal is so great, why the heck give it away?
    2. The deals rarely favored in cap ex. Cash flowing $200 a month is great but one big cap ex item wipes out multiple years of cash flow.
    3. Tenant class is usually below average.
    4. Investors have no idea what they are getting themselves into. They don’t know the area, they don’t understand what makes the market competitive, they don’t understand the costs associated with their tenant classes.

    As a disclosure, I don’t own turnkey properties. But I have many clients that do. The cool thing about being a CPA is that I get to see how the properties actually perform over a long period of time. And I’ve concluded that I’ll never personally own turnkey.

  5. Christopher Throop

    Hmm… That’s good stuff to think about, and I really like that your opinion is based on some great behind-the-scenes information.

    Just to offset your opinion somewhat, and based on my own personal experience as a turnkey investor, I would propose that turnkey CAN be a good investment if, as you suggest, some time is spent learning what you are getting yourself into.

    I don’t think of turnkey as a passive investment – at least not in the beginning. Time, effort and money need to be spent to ensure that the investment is solid. The city, the neighborhood, the vendor, the likely tenants, etc. And even with everything in alignment, there are very few home runs to be had in turnkey real estate. I wouldn’t say the deals “are so great”, but I would say they can be good investments that will provide much better returns than the typical index fund. Turnkey is for busy people who probably don’t want to be full time real estate professionals. In real estate, I believe you often profit from a deal in relation to the amount of time and energy (or money) you can devote to it. So turnkey investors like me, often with limited resources, don’t get crazy deals because we are likely compromising for some convenience. We can however find solid investments that can be long-term winners and, maybe, offset some passive losses in the meantime.

    Cap ex should certainly be factored into anyone’s calculations. Learning how to adequately analyze a deal should probably come before any purchase. If the deal can’t support cap ex reserves (in addition to regular maintenance) then the investor should think twice.

    Now that I’ve said my piece in defense of turnkey, I’m curious what approach to RE investing you would recommend. Based on the rare privilege that you have to look behind the scenes at all kinds of RE investments, what form of real estate investing do you prefer over turnkey? From a financial standpoint, what seems to work really well?

    And by the way, thank you for all the generous input you have provided to the BP universe. I always appreciate your contributions.

  6. Alina T.

    Great post Brandon! Very creative too on #3. Question about strategy #3: you don’t mean to say, “don’t invest in real estate business as passive investor”, right? In other words, just like your parents purchased a share in your accounting business, one can purchase shares in investment property as a passive investor (aka limited partner in a partnership). This will in turn qualify this income as passive? Does this sound right?
    Thank you!

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