Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part V. Real Estate Income and Deductions
For many, many years, real estate has been one of the great bastions of tax planning. Real estate offers many of the same tax benefits as owning a business. It also offers the opportunity for tax-deferred growth—often for decades at a time and with no requirements that would force you to recognize the gain. Under current tax law, real estate also offers the opportunity to report losses on a tax return while maintaining a positive cash flow to the owner.
There are also many nuances in the tax law related to real estate, which can make it confusing and difficult to get your tax planning and reporting right. However, once you understand the strategies contained in the chapters of Part V, you will be well on your way to fully harnessing the tax-saving potential of real estate ventures.
Chapter 23. Real Estate Losses
Your Loss Is Your Gain
Real estate has long been the traditional safe haven for taxes. It provides an opportunity for tax-free (deferred) cash flow. It also offers tax-deferred appreciation, or growth in the value of the investment. It even offers the opportunity to sell assets and purchase others without incurring any tax on the realized gains. Combining these tax benefits with the ability to use high amounts of leverage in the purchase of real estate makes for an ideal way to produce tax-favored income for the short- and long-term future. In fact, real estate is the most commonly used investment for those seeking tax incentives. Illustrating the point, after some modifications to the real estate tax laws in 1986, a committee member—Fortney H. (Pete) Stark, (D-CA)—on the House Ways and Means Committee famously stated: “It’d take a genius to invest in real estate and pay taxes.”
Of all of the tax-reduction strategies that real estate offers, one of the more complicated and lucrative strategies is the ability to use losses from the real estate to offset income from other areas of the tax return. In the case of most income sources (such as investment income or business income), losses are not that beneficial because, by definition, you always lose more money than you save in taxes. In real estate, however, this is not always the case. Because of the depreciation that is taken on the real estate, it is possible—even common—to have a positive cash flow from a property while at the same time reporting a loss on your tax return.
Example Olivia owns a townhome that she uses as a rental property. She purchased the townhome for $200,000 and made $50,000 in improvements, bringing her total cost for the home to $250,000. She rents the home for $1,000 per month, bringing a total gross income of $12,000 per year. Her annual expenses (including mortgage interest, property taxes, and maintenance) are about $5,000 per year. This leaves Olivia with a positive net cash flow of $7,000 per year ($12,000 income – $5,000 expenses = $7,000 net positive cash flow).
In addition to the real, out-of-pocket expenses, Olivia is also able to claim $7,250 of depreciation expense on her tax return. Doing so creates a reported loss of $250 on her tax return, which offsets her other sources of income. Even though she had a cash flow income of $7,000, on her tax return it appears as if she had a loss.
Depreciation is taken on real estate to account for an assumed loss of value over time as the property ages. However, this assumption of real estate values going down is rarely true. In reality, the value of real estate usually goes up over time. With real estate you receive the simultaneous benefit of tax deferral on the true increase of the property’s value and annual tax deductions from the depreciation of the property. It’s like earning wages from your employer but reporting the income on your tax return as a deductible expense.
Because of the tremendous benefits that can be gained from this phenomenon, some rules have been set in place in an effort to limit the benefits of this strategy. There are three important facets of this limitation that you need to understand to plan properly for the effects of real estate income on your return. These three items are:
· Treatment of passive losses
· Active participation rules
· The real estate professional designation
Treatment of Passive Losses
Passive income comes from ownership in real estate or businesses in which a person does not actively participate. For example, if you gave $10,000 to a friend to help him start a business, but did not actually perform labor in the running of the business, that $10,000 investment would be considered passive and any income would be considered passive income. In general, passive losses can be deducted only from passive income. Losses that exceed income in a given year must be carried forward to a future year to be deducted against future passive income.
Real estate rental activities are automatically presumed to be passive investments. As such, losses in real estate cannot be deducted from other income (such as wages, investments, or business income) in order to reduce your Adjusted Gross Income (AGI). There are several exceptions to this automatic assumption, most of which are very narrow and uncommon. One of the exceptions worth noting is that rentals in which the average stay is seven days or less (such as hotels) are not considered passive income, but are instead considered an active business (as long as you materially participate in the business and are not just a passive investor).
Even if your rental activities fall into the passive-loss rules, there are two important instances in which some or all of your passive losses are allowed as deductions against other sources of income. The first is when you actively participate in the rental real estate activity and the second is when you meet the guidelines that classify you as a real estate professional. Each of these two exceptions is described in the sections that follow.
Active Participation Rules
If you actively participate in real estate rental activities you may qualify to deduct up to $25,000 of passive real estate losses each year. To be considered an active participant in real estate you must:
· Own at least 10% of the property that has a loss.
· Actively participate in management decisions. You are allowed to hire a property manager, but must do more than simply ratify the manager’s decisions. Such activities might include approving new tenants, determining rental terms, and approving expenditures.
In addition, the $25,000 allowable loss may be limited by your Modified AGI (MAGI). The full loss is allowable for taxpayers with an MAGI up to $100,000. The allowable loss is reduced by $0.50 for every $1 of MAGI over the $100,000 limit, with the allowable loss being reduced to $0 when AGI is $150,000 or greater. Modified AGI is calculated as follows:
+ Adjusted Gross Income (AGI)
– Social Security or Railroad Income included in AGI
+ Deductions Taken for Passive Activity Losses
– Income from Passive Activities
+ Loss Allowed for Real Estate Professionals
+ Deductions Taken for Traditional IRA Contributions
+ Deductions Taken for Student Loan and Tuition Expenses
+ Deduction for Half of Self-Employment Tax
+ Excluded Interest from Education Bonds
+ Employer-paid Adoption Expenses
+ Deductions Taken for Domestic Production Activities
– Income from a Roth IRA Conversion
= Modified Adjusted Gross Income (MAGI)
To determine the allowable loss you must first combine all income and losses from all of the real estate activities in which you actively participate. The net loss is then applied to the net income from any other passive activities. Any remaining amount can then be used against other types of income on your return.
Caution The rental income (or loss) from a personal residence is disregarded in the calculation of the allowable loss. The property is considered a residence for these purposes if your personal use of the property exceeds the greater of 14 days or 10% of the days that the home is rented at fair market value.
The Real Estate Professional Designation
Real estate rental activities will not be considered passive—allowing you to avoid the limits on losses—if you qualify as a Real Estate Professional. There are several tests that must be met to qualify as a Real Estate Professional. The first requirement is that you must materially participate in the management of the property for which you are making the claim. You are considered to materially participate if you meet at least one of the following criteria:
· You work 500 hours or more per year on the property.
· You perform substantially all of the work that is required for the property.
· You work more than 100 hours per year on the activity and no one else works more than you do on the property.
· You materially participated in the property in any 5 of the previous 10 years.
Material participation is determined for each property individually. If you have multiple properties, it can become very difficult to meet those tests, even if you spend all of your time working on those properties. Because of this, there is an option available that allows you to elect to aggregate all of your real estate properties into one overall activity. By doing so, the cumulative number of hours spent on all of the properties can add up to meet the material participation rule.
Caution While electing to aggregate all of your real estate properties into one overall activity has its advantages (such as being able to deduct your losses against ordinary income, regardless of AGI), it also comes with significant disadvantages. First, once you have made the election you must continue with that election in all future years in which you qualify for it. You may not revoke the election without permission from the IRS.
Second, once you have made this election you cannot claim carried-over losses on a property when you sell it, until you have sold all of your properties, since they are treated as one activity.
Before electing to aggregate your activities for the purposes of qualifying for material participation I strongly recommend speaking with a qualified tax professional to fully understand and analyze all of the future implications of doing so.
In addition to the material participation test, you must also meet each of the following tests to qualify as a Real Estate Professional:
· More than 50% of your personal service in all of your business activities is performed in real property businesses in which you materially participate. Time spent as an employee does not count toward the 50% threshold unless you are a more-than-5%-owner in the business in which you are employed.
· You spend more than 750 hours of your personal service time in real property business in which you materially participate.
· For married couples, the tests above must be met by one spouse (you cannot combine the time spent by both spouses in order to meet the test).
If you are truly in the real estate business, have a high AGI, and have significant rental losses, using this designation may bring a real benefit.