When you invest in rental properties or businesses where you aren’t actively involved, you have to understand the intricacies of passive losses. This is where the the tax laws can benefit you or hurt you, depending on how you handle your filing. In most cases, passive losses (also known as passive activity losses) are a detriment to investors. However, there are strategies you can use to make the most of the situation.
Passive loss rules were established back in 1986, and they were designed to limit the amount of losses that an investor can deduct on passive activity. For example, a rental property is considered “passive income” for most real estate investors. The same goes for a business where you are not actively involved for at least 500 hours in a calendar year.
For most investors, a loss will help reduce their total taxable income and that can be a good thing if their taxes are handled correctly. In general, our goal is to make more money. From a tax standpoint, showing losses on certain investments can be a benefit. Before the passive activity loss rules went into effect, high-income individuals were taking advantage of a loophole that allowed more passive income losses to be written off (thus significantly reducing their overall taxable income). These passive activity loss rules essentially closed that loophole and put stronger limits on what losses could be deducted.
Because rental properties offer large depreciation deductions, it’s very common for these investments to show losses—even when you earn a net profit. Net losses are usually easiest to show in the first few years of property ownership as that’s when repair and renovation expenses tend to be highest. Likewise, businesses can show net losses even when they are technically profitable for the year.
Though you may think a loss is just a loss, but the IRS sees it differently. They treat passive losses separately from active losses. Passive activity losses can only be used to offset other passive income. So, if you earn profit from one passive investment while having a net loss in another, you can only use that loss to offset what you earned from the other passive investment. You cannot use it to reduce your primary (active) taxable income. In other words, they are generally not deductible in the traditional sense.
It should also be noted that capital gains and dividend income are not considered passive income. Therefore, passive activity losses cannot be used to offset those types of income either.
There are two exceptions to the passive activity loss rules:
An active participant in a rental property who actively makes decisions regarding their investment properties. You might screen your own tenants, self-manage the property (with no property manager), you take care of the repairs or you personally review and approve repair expenditures. An active participant can deduct up to $25,000 of passive rental income losses as long as your modified adjusted gross income (MAGI) is less than $100,000. The more you earn, the more your ability to deduct losses will dwindle. If you make more than $150,000 in a year, you won’t be eligible to deduct any passive losses.
As for the real estate professional exemption, it’s not as simple as just going out and getting your Realtor® or broker license. The IRS defines a real estate professional as someone who spends at least 751 hours a year working in real estate businesses. Plus, you must actively participate in ALL of your rental properties. If this describes you and you expect to have substantial passive losses, keep a very detailed log of all your time spent working at each property.
If you find yourself in a situation where you experience rental property losses, but are unable to deduct them this year because your MAGI is too high or you have more passive losses than passive income, don’t panic. You should know that any unused passive losses can be carried forward into future tax years and applied toward passive income you may earn later. You can also use your unclaimed passive activity losses to reduce your income when it comes to sell the property.
On paper, passive losses seem like trouble for passive business and real estate investors. However, like all tax rules, there are strategies you can use to either minimize the damage or possibly even manipulate them in your favor. You just have to know what you are doing and have a smart tax plan in place.
Talk with your financial advisor about your passive activity loss options and build a tax plan that allows you to make the most of your investment portfolio. If you are looking for an experienced tax advisor to guide you through the process, contact Illumination Wealth today. Let us show you how to maximize your investments and reduce your tax liabilities.