New real estate investors often get excited about the potential for using passive losses to offset other income. However, there are a few key facts that every real estate investors needs to know when it comes to taking advantage of passive losses especially if their real estate activity is only part-time while and not a full-time job. Lets start with talking about income in general.
Three Types of Income and Losses:
1) Active income;
2) Portfolio income; and
3) Passive income.
These distinct types of income are taxed differently. Also, losses you incur in one category may only be applied to income in that same category, with a few exceptions that we will discuss below.
1) Active Income: Think of active income (or losses) as the income you earn from taking action or performing a service. Active income includes income from salaries, tips, commissions, or self-employment income from running a business. If you are running a business, there is generally a requirement that you materially participated or actively managed the business for the income to be deemed active income. This is the difference between a person who works in the business and a silent partner who invests money in the business but does not work in the business. If you invest $25,000 in a pizza restaurant and also work 15 hours per week in the restaurant to make it successful, any income you earn would likely be active income.
2) Portfolio Income: Portfolio income (or losses) is when a person is not performing a service to create the income. Portfolio income is earned when an investment or a thing you created is generating income. For example, interest on a savings accounts or interest from a bond is portfolio income. Portfolio income can also be capital gains from selling investments at a profit. If you purchase $5,000 of Microsoft stock and sell it for $6,000 two years later, you have a capital gain of $1,000 which is portfolio income. If your Microsoft stock paid $200 in dividends while you held it, that is also portfolio income.
3) Passive Income: Passive income (or losses) are usually from a business in which you do not materially participate, think of it as the opposite of active income. If you invested $25,000 in a pizza restaurant in return for a percentage of the profits, but have no other involvement with the business, any income you earn would likely be passive income. Passive losses can't be used to offset gains from active income or portfolio income unless certain factors apply.
In situations where you can't take passive losses in your current tax year you may carry the losses forward to the next tax year to offset future passive income. For example, your $25,000 restaurant investment led to a passive loss of $2,000 the first year because the restaurant was just starting up. You can carry that loss forward if you have no other passive income for the year. If next year the restaurant is more profitable, and you earn $3,000 in passive income, you would only have to pay tax on $1,000 of this income because the previous $2,000 loss would offset the remaining passive income of $2,000. Note: Passive losses related to real estate activity are treated differently and are explained further below.
Pizza business example:
Year 1 -$2,000 passive loss is carried forward to next tax year
Year 2 $3,000 passive income
Year 2 $1,000 in taxable passive income
Taking Losses from One Category of Income to Another
One of the exceptions where a person can take losses from one category of income to another is for capital gains. You can deduct capital gains losses up to $3,000 per year against your active income. So, if you bought Microsoft stock for $10,000 but sold it for $7,000 your $3,000 loss could can be deducted against the income your earn from your job. As stated above wage income from a job is active income. Losses above $3,000 can be used to offset other capital gains or carried forward to the next tax year to be deducted. For example, if your loss on Microsoft stock was $4,000, you could take $3,000 against the income from your job this year and then take the remaining $1,000 loss against your job income next year.
Taxes and Real Estate: Limits on Passive Losses
When it comes to most passive income from business, if you materially participate in the business income or losses are treated as active income or losses. Except if your business is real estate rental income. If you run a part time real estate business that earns rental income the IRS will limit your ability to take losses against other income, even though you materially participated in the business.
This comes as a surprise to many new real estate investors. Particularly because you are likely to have some losses in your first few years due to the large number of deductions you can take in your real estate business. Fortunately, there are two exceptions to this passive real estate income rule which will allow you to deduct all your real estate losses.
Real Estate Professional Exemption
The first is if you or your spouse are a real estate professional as defined by the IRS which requires working a minimum of 751 hours per year in real estate during the year. In addition, your personal involvement in the activity meets the standard for material participation. If you or your spouse meet these two criteria, you can deduct all your losses from your rental activity. Essentially what the IRS is saying is if real estate is really your job because you work at least 751 hours per year doing it (equal to about 15 hour every week per year) you can take the losses.
Income Level Exemption for $25,000 in Loses
The second exception which allows deducting your passive real estate losses, is based on your income level. There are two requirements here. First, you have “actively participated” in managing the real estate, that is you made the material management decisions related to the real estate activity. Second, your modified adjusted gross income is below $100,000 for the year. If you meet these two requirements you can deduct up to $25,000 in passive loses. If your modified adjusted gross income is between $100,000 and $150,000 your losses will begin to be phased out until you reach $150,000. Any losses you can’t take this year may be carried forward to next year. See IRS Publication 925 and the instructions for Form 8582 to learn more about this subject.
Taxes and Real Estate: Home Sale Exclusion for Capital Gains
There is one investment that allows you to exclude between $250,000 and $500,000 from capital gains taxes and is one of the greatest ways to create tax free wealth. This is from selling your primary residence and is explained in IRS publication 523. If you have lived in your home as your primary residence for at least two of the preceding five years you can sell your home and pay no capital gains taxes up to $250,000 if you are single and $500,000 if you are married.
For example, if you and your spouse bought a home or a condo for $200,000 and you lived in it for four years and now it is worth $350,000 you can sell the property and pocket the $150,000 in profit, tax free. If you and your spouse had bought your home for $200,000 and sold it for $700,000 you could pocket half a million dollars tax free. Pretty sweet! You can put the money into your next primary residence and repeat the process again.
For more detailed strategies on real estate investing see the relevant chapters in the book Become Loaded for Life available on this website.