Harsh Tax Reality for Passive Investors in Real Estate

Nov 9th 2017
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The tax laws authorize various incentives for investors who move money into real estate ventures and other kinds of tax shelters, such as limited partnerships. The key attraction for investors is that these real estate deals are designed to generate large paper losses, at least in the short term.

But the tax rules become harsh and complicated for real estate investors who incur losses deemed to be “passive.” Generally, investors can’t make use of these losses to offset income they derive from salaries, self-employment income, interest, dividends, sales of investment properties, pensions and withdrawals from IRAs or other retirement arrangements.

Disallowed losses are suspended and carried forward indefinitely to later taxable years. The passive loss rules prohibit investors from deducting their losses until they realize passive income or sell their passive investments.

Which real estate investors are subject to the convoluted restrictions on passive losses? Only passive investors — meaning individuals who don’t "materially participate" in their venture’s operations (not investors who do materially participate), and meaning individuals actively involved in business operations.

How actively involved must investors be to free themselves from the passive-loss limitations? The involvement must be year-round, on a "regular, continuous, and substantial basis."

Passive investors can’t use losses to offset what they receive as "active income" (salaries and other earnings) or "portfolio income" (dividends and interest, as well as profits from sales of stocks and other investments). Generally, they’re able to offset passive losses only against their income from other passive activities.

Passive losses that aren’t immediately deductible aren’t valueless. They’re put into suspended animation, not erased. Investors can store unused losses for later years until they can apply them against income from passive sources. Lastly, investors can offset the remaining unused losses against salaries and any other kinds of income from nonpassive sources when they sell or otherwise dispose of their interests in properties that generated passive losses.

Real Estate Professionals

There’s an important exception from the burdensome rules for passive losses for people in the real estate business. The exception applies to persons who materially participate in the operation of real estate enterprises, whether as developers, builders, landlords, managers, brokers, or the like.

Which real estate professionals benefit from the exception? Only those who pass a two-step test for the year in question. First, they devote more than 50 percent of their personal services to real estate businesses. Second, they work more than 750 hours in the businesses in which they materially participate as developers, landlords, etc.

There’s a further requirement for professionals who work as employees. They have to own at least a 5 percent share of the employer's business. So someone working for a real estate development corporation and owning none of its stock remains subject to the passive loss rules on his or her personal real estate investments.

Relief for qualifying individuals who actually spend most of their time in real estate. Their rental losses aren’t deemed passive. Therefore, they can offset their losses against other kinds of income, such as wages, bonuses, profits from unrelated businesses, interest, and so forth.

The exception for people in the real estate business isn’t unlimited. It provides no relief for individuals with losses from other kinds of real estate tax shelter deals, such as limited partnerships. The passive loss rules allow these individuals to offset their losses only against passive income derived from similar shelter arrangements.

Limited Break for Active Managers

The tax code tacks on another exception from the rules for passive losses for people in the real estate business. This one okays a measure of relief for individuals who meet an “active management” test, a stipulation that’s much easier for them to satisfy.

Test Requirements 

Among various other responsibilities, you (or your spouse) have to participate in management decisions, such as approving tenants, setting rental terms and approving capital improvements projects. And you (together with your spouse) must have at least a 10 percent interest in the property. Satisfy those requirements and you can deduct rental losses from salaries and other types of income.

The deduction for rental losses is capped at $25,000, and it’s not for fat cats. The write-off begins to phase out when your modified adjusted gross income exceeds $100,000 and vanishes entirely when it tops $150,000. Unused losses can be carried forward to later years.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 225 and counting). 

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