By Dr. Daniel Smith, WCI ColumnistGoes the old saw, “Nothing in life is certain but death and taxes.” I would add to that proverb with this qualification: “Though while death is dichotomous, taxes are a spectrum.” You see, tax liabilities vary significantly from person to person—both in absolute dollars and as a percentage. A prudent two-attorney couple making $300,000 per year might have a lower effective tax rate than the gentleman who, in the same year, makes $80,000 running a lawn service.
This is because the tax code is one of incentives. What the federal government likes, it incentivizes. For example, the 2022 Inflation Reduction Act (which according to analyses by The Economist and the Tax Foundation might marginally increase inflation . . . but I digress) set aside hundreds of billions of dollars for renewable energy incentives because the president and then-Democratic Congress wanted Americans and businesses to invest money into energy sources less predicated on coal and oil. Similarly, the federal government wants you to save for retirement, buy a home, have kids, and donate to charity. Things like tax deferrals for ERISA-protected accounts (IRAs, 401(k)s, deferred compensation plans, etc.), deductions for mortgage interest, deductions for charitable giving, and credits for child dependents are all carrots the IRS uses to encourage you to do them.
Most germane to this topic, however, is the fact that the federal government wants you to run a business and invest in it. And if you're a real estate investor, all the better.
Tax Loopholes and Slick Accountants
Before we dive into the devilish details, a word of caution. Be wary of accountants or attorneys who promise you these “massive loopholes that will save you hundreds of thousands in tax dollars.” No offense meant to either profession, but there are those even in white collar jobs who’ll overpromise for the money (whole life insurance, anyone?). Loopholes are to accounting what “shocking” headlines are to journalism—likely an inch of fact and a foot of hyperbole.
In fact, the majority of tax write-offs have at least some legitimate purpose (or at least a legitimate origin), and most of those have a basis in business. For example, when WCI Founder Dr. Jim Dahle gets to take his employees (and maybe content writers, too?) to a cool retreat for some meetings and team building, that’s a legitimate business expense. Uncle Sam is happy to let Jim pay for that with pre-tax money. It is not, however, a loophole. Don’t let anyone promise you tax El Dorado only to later find that it’s Reno, Nevada. Uncle Sam is a jealous taskmaster, and professionals making six-figure incomes with four-figure taxes look mighty suspicious. Remember, the G Men didn’t get Al Capone for gambling and rum-running but for tax evasion.
More information here:
13 Ways to Lower the Tax Bill on Your Income
A Brief History of Real Estate Deductions
Prior to 1986, investors could claim losses from real estate activities against their active income, whether their involvement was as a real estate investor or an operator of the property. Hence, those with large amounts of taxable income looking to shelter that cash from the IRS would purchase real estate holdings, depreciate them in an accelerated fashion, and then pay substantially less in taxes as a result.
The Tax Reform Act of 1986 established section 469 of the tax code which states that the default treatment of any gain or loss from a trade or business, including rental real estate, is considered passive unless the taxpayer “materially participates.” Now, by default, any losses you sustain as an investor are passive and cannot be considered as losses against your active income (W2 or 1099). Those losses also can't be applied to dividends, capital gains, income from annuities, royalties, coupon or interest payments on bonds or CDs, etc.
Deductions and Material Participation
Hold that in your working memory for a moment, and let’s talk about deductions. We shall reconcile the two ideas shortly. A deduction is simply a legitimate business expense, period. If your business is selling bananas, then your “deductions” may be your rent, utilities, payroll, taxes, and the cost of your bananas. Similarly, real estate deductions are simply business expenses that have been incurred, like repairs, a new carpet, or a new roof.
Let’s say you own a single family home (SFH) rental that needs the walls painted and a leaky faucet fixed. These expenses are deducted immediately from your revenue. If you had no other job but that rental and performed most of the work of running the rental yourself, then you have materially participated in that rental. Material participation is an IRS classification delineating passive investors from active business owners.
Why is this important? If you're an active business owner, you can deduct your business’ losses from your other income. Imagine you had a particularly bad year and lost $5,000 on the rental; imagine that you also were paid $10,000 that year for odd jobs (that amounted to fewer hours than you worked your rental). In the eyes of the IRS, that $5,000 loss from your primary business offsets that amount of your $10,000 in other income. Thus, your net income for that year would be $5,000 total.
Material participation tests are listed below, verbatim from the IRS:
- You participated in the activity for more than 500 hours.
- Your participation was substantially all of the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
- You materially participated in the activity (other than by meeting this fifth test) for any five (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Last, the IRS stipulates that material participation still doesn’t allow you to claim losses against ordinary income unless you have Real Estate Professional Status (REPS).
Active vs. Passive Investment
Now, let’s contrast this with passive investment. Say you held that same rental with the same bad year and losses of $5,000, but you had a property manager (PM) do the majority of running that rental for you. That $5,000 loss is now a passive loss because you were a passive investor. You set up the rental and handed the running over to the PM. From a tax standpoint, you can’t deduct those losses from your $10,000 income. That loss stays in limbo until you have some passive gains to offset them, things like net positive income from the rental or proceeds from a sale of that property.
More information here:
10 Tax Advantages of Real Estate – How Many Can You Name?
Capital Improvements and Depreciation
You realize your PM isn’t all that good and you resume running the rental yourself the following year. As storm season would have it, you realize your rental needs a new roof, which will cost you $14,000. This will clearly be more than just paint or a quick fix; this will be a large investment of capital, much like the purchase of the home itself. In fact, that’s exactly what the IRS calls this kind of expense—a capital expense—because it involves a relatively large amount of capital relative to the business. Capital expenses (aka capital improvements) are treated differently by the IRS, in part because of the large amount of money they entail and because capital improvements are expected to have a longer predictable lifespan (the IRS requires more than one year).
You can deduct equal bits of the entire cost every year over the course of the improvement’s lifespan until the improvement is completely consumed. This piecemeal method of deducting something is called depreciation, because the capital improvement depreciates in value every year. If the average shingle roof lasts 27.5 years, it can be expensed (depreciated) by 1/27.5th of the value every year. For our $14,000 roof, that would amount to $509.09 yearly in depreciation expense that we can subtract from our income as a business owner. We can do that every year for 27.5 years. For more details, you can see IRS pub 946.
Active Participation
Fast forward a few years. You now have 20 doors in your burgeoning real estate empire, and the spirit of Robert Kiyosaki beams down upon you benevolently. You’re becoming a bit frazzled at the end of long days of unclogging toilets and serving eviction papers, so you decide to try a PM again. More facile than you at screening tenants and with teams in place for the 200 more doors the PM already manages, your rentals and bank account thrive with barely a drop in revenue. You get a part-time job driving buses for the local high school (great benefits, right?) and scan Zillow in the meantime for deals. The dream continues until April 15 of the following year.
The crisp clack of sensible shoes disrupts your reverie, and the tax man, despite your obvious repugnance at his presence, presents you with your tax bill for the year. He pulls a stylus from his pocket protector and gestures in a professorial, avuncular fashion on the portion of IRS Publication 925 which lays out the passive activity rules. A corner of his mouth pulls into a smirk as he extends his hand palm up toward you. Still smarting from the rude awakening you received at the start regarding passive activity and material participation rules, you’d been adroitly reading the tax code all these years and courteously direct the tax man’s attention to the active participation section.
Active participation is a less rigorous standard for participation and only requires that you make bona fide management decisions about your rental. The IRS lists examples of approving new tenants, deciding on rental terms, approving expenditures, and similar decisions. The limit of deductions on losses is $25,000 if Married Filing Jointly (MFJ). This exception does have a phaseout that starts at $100,000 MFJ and diminishes by $1 of deduction for every $2 of income above the $100,000 cap. That means if you and your spouse make $150,000 together, the deduction goes away completely.
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Big Money or Petty Cash?
While many of the readers here have phased out of the active participation bracket, this tool can still be used by married residents or medical students who fall below the threshold. For those of us with the privilege of being in higher tax brackets, Real Estate Professional Status (REPS) and material participation are always viable options.
Similarly, the short-term rental loophole is a less stringent way to pay less tribute to Uncle Sam as it only requires 100 hours of participation as opposed to 750 hours for REPS and 500 for material participation. This is because the IRS actually considers short-term rentals not to be a rental activity per Regulation Section 1.469-1T(e)(3)(ii)(A) where the regulation stipulates that the use of a real property is not considered a rental activity if the average period of customer use is seven days or less. Thus, it is not subject to the passive activity loss rules listed above.
Just remember not to let the tax tail wag the investment (and time) dog.
If you are interested in private, passive real estate investing opportunities, start your due diligence with those who support The White Coat Investor site:
Featured Real Estate Partners
How have you used real estate investing to your tax advantage? Are there any other ways to lessen your tax burden with your real estate holdings?
Thanks so much for this article. For high income earners I learned the hard way that I now have a bunch of losses suspended into… eternity?
We bought a rental a few years ago and it’s been a nightmare. Excluding depreciation we lost on average 6-8k annually. It’s our only rental and I am wondering if we sell the home, would any of those losses offset our w2 incomes? We are very fortunate income earners but this house is killing us, albeit slowly. Or do those suspended losses get lost forever as we don’t plan to buy another rental again. Clearly we should focus on our day jobs.
Good news, you can unlock those losses and use them against ordinary income when you sell the property.
In retrospect, what’s the problem with the property? Did you pay too much? Are you managing it poorly? Did you not put enough down? Did something change and surprise you? Did you expect to lose $6-8K/year when you bought?
Correct, passive losses can be “unsuspended” when “substantially all” of your rental real estate is sold. If you have this house as well as a commercial property which represents the majority of the real estate value owned by an entity (sole proprietorship, partnership, corporation, etc) and just sold the house, then the losses would still be considered suspended under the passive activity loss rules.
Jim asks some germane questions. Depending on your answer, you might benefit from a number of simple (not easy) fixes.
Interesting. I don’t think I realized you needed to sell all your real estate.
I suppose it’s the way to keep people from deducting losses without being a REP and actively participating. Or could just be some obscure provision an aid in a senate finance subcommittee put in because someone gave them a nice steak dinner to do so.
I believe this is correct but misleading to the reader if not careful. I agree that extra passive losses (beyond RE sale proceeds) become ordinary losses when an entity divests of it’s RE holdings; but this can be a single-property LLC, etc… and when “the business shuts down” the losses can indeed be used against your W2, even if you have other RE holdings in separate LLCs/partnerships, etc… (same goes for syndications if they get to the point where you actually lose money… silver lining…)
If you hold everything directly in your name or all in one holding entity, AND you hold a bunch more RE, then I’m not sure, but even if the losses carry-forward to your next passive deal, that’s not the end of the world, b/c you do in fact own more RE and will be able to use it to offset gains.
It would be helpful to have a real estate CPA chime in here, but the “activities” or businesses need to be explicitly separate. Having 4 LLCs with one property each, but aggregating them for tax purposes (like when one elects for real estate professional status, reg 469C(7)(A)) disallows the losses when disposing of one LLC’s property. Similarly, you’d need separate books for each LLC as opposed to using a single ledger or worse a single bank account (if you were the sole owner, and the LLCs were single member LLCs). It seems to depend on the manner in which the activities were treated and accounted for prior to the year(s) in which they were disposed.
I found this article from 2008 which gives a little more background
https://www.thetaxadviser.com/issues/2008/may/disposingofanactivitytoreleasesuspendedpassivelosses.html
Can you please comment on Qualified Opportunity Zone funds? The tax treatment of these seems very appealing, and I like the mission-driven aspect too.
QOZ funds are useful only when you are starting by owning something with capital gains. I wouldn’t ascribe much to the mission though. Most QOZ operators are looking at investments that qualify as OZ in name only. Because those that are REALLY in an OZ aren’t good investments.
But basically you get some nice additional tax benefit that is great IF the investment is one you’d invest in anyway, but not large enough to turn a bad investment into a good one.
Here are those tax benefits:
https://www.irs.gov/newsroom/opportunity-zones
The benefit is much smaller than it was a few years ago given the deadline, but maybe it’ll be extended.
To piggyback off Jim’s comment, as the QOZ tax breaks sunset, the true “opportunities” are becoming fewer and fewer. Technically you can make your own QOZ fund and have six months or a year (I forget) to invest in either businesses or real estate in one of these zones, or your fund can invest in a QOZ fund. I think Origin has one (I don’t own any Origin funds or get paid to say that fyi…though I wouldn’t say no to some cash if they offered) that’s a QOZ fund. I think more technically (ask your CPA to corroborate), you only have to have *most* of your own QOZ fund money invest in QOZ spaces or another QOZ fund, and I think the number is something like 90%. So you could have your own “QOZ fund” that’s invested 90% into another QOZ fund and invest the other 10% on a flyer like bitcoin or penny stocks or whatever you like.