Last week, we talked about passive losses and some of the basic things that real estate and business investors need to understand about them from a tax deduction perspective. In this article, we are going to focus on some wise strategies you can use to make the most of any suspended passive loss claims you have.
Though there are limits on how much of your passive losses you can write off and these deductions only apply to your passive income, there is one passive loss rule you must remember. You can suspend excess passive losses into future tax years. In other words, if you exceed a certain income threshold and aren’t able to deduct all your passive losses in your modified adjusted gross income (MAGI) this tax year, you can actually roll them over into future years.
Many people hear the word “loss” and think that it’s a bad thing. Passive losses are something that smart investors will benefit from because it doesn’t necessarily mean the investment is losing. It’s just a matter of how you factor in your expenses (including depreciation on a real estate investment) against your net passive income. Passive losses can actually be to your advantage, especially in instances where you experience depreciation and/or major repairs and renovations have been made (thus incurring more expenses in a certain tax year).
However, you are only able to claim a certain amount of your passive losses. When your income is below $100,000, you are able to take up to $25,000 of passive losses. That ratio goes down once your income goes above $100,000 and then phases out completely once you reach the $150,000 plateau. When your income exceeds $150,000, any passive losses that occur will become “suspended.”
The good news is that those suspended losses aren’t lost forever. They can be used in subsequent tax years. The fear for investors, though, is never being able to utilize these losses. You don’t ever want to see large amounts of passive losses being suspended and rolled over, and you also don’t want your suspended passive loss balance to keep increasing each year.
You have to be smart about how you handle your suspended passive losses and utilize them to your best advantage each tax year. The following are some tactics you can use:
This should probably go without saying, but it’s probably not a good sign if you are seeing significant passive losses year after year unless each investment is realizing the benefits of depreciation. If your cash flow is down and your suspended passive loss balance is going up each tax year, then something is clearly wrong with the underlying investment. For instance, a real estate investment might see you have losses in the first few years of your investment because you put a lot of money into the initial purchase and renovation that is being expensed and depreciated. Looking 5 – 7 years out, that investment should be generating higher cash flow and passive taxable income as time goes on. If it is not, then you probably not generating adequate income as a whole and not just in terms of your passive loss tax benefits.
When you sell an investment property for a gain, it will then allow you to use the suspended passive losses from any properties you own. The losses don’t have to come from the property you sold. This is often a good strategy when real estate investors have suspended passive losses. You can liquidate one property and shelter your gains using the suspended losses as well as passive losses generated on from other investments.
You can also tap into passive losses through business investment outside of your real estate portfolio. A passive business investment can generate more passive income to offset passive losses. For a business investment to be considered passive, however, there are some requirements:
To this point, we’ve been focused on how to utilize suspended passive losses. Another strategy to consider is doing something to prevent passive losses from being suspended at all. Licensed real estate professionals who spend a minimum of 750 hours a year devoted to general real estate activities and at least 500 of those hours working on their real estate portfolios are not susceptible to passive loss tax limitations. In this case, your earnings are considered “active” income as part of a full-time real estate career. Real estate professionals who qualify (even if it’s your spouse getting licensed and putting in the time) can deduct all losses, passive or otherwise.
When it comes to managing your real estate and business investment portfolios and working all the tax laws in your favor, you need an expert guide. Passive loss rules are simple in theory, but complex in practice. It helps to work with a financial advisor who understands your portfolio and all the tax implications of your passive and active income.
At Illumination Wealth, we can help you make the most of any current and suspended passive losses as you refine your real estate portfolio and develop a sound tax plan. If you would like to learn more or set up a no-obligation initial consultation with one of our financial specialists, contact Illumination Wealth today.