By Dr. James M. Dahle, WCI Founder
Investing in real estate can be a risky, time-consuming, illiquid investment. However, one of the best parts of being an investor in equity real estate (at least outside of a retirement account or a REIT structure) is that you can depreciate the buildings on the property. Under current law, bonus depreciation can be over 60% of your investment in the first year. It's pretty awesome to invest $100,000 and get a $60,000 deduction on your taxes that same year.
Unfortunately, there is a general tax doctrine that prevents many investors from actually being able to use that deduction. It turns out that you can only use passive losses to offset passive (i.e. rental) income. If you don't have any passive income, those losses are simply carried over indefinitely. This is a lot like the long-term capital losses that many of us carry around for years after tax-loss harvesting our taxable mutual fund portfolio. Those losses offset any long-term capital gains you may have, and you can use $3,000 per year against your ordinary income. But after that, they are simply carried over.
However, there are two ways to actually use those passive real estate losses against your ordinary income rather than waiting until you have enough rental income to use them. That's a real win. Not only do you not have to wait years to use them, but you can use them to offset income that would normally be taxed very highly.
Method #1 Real Estate Professional Status
If you qualify as a real estate professional, you can use real estate losses against your ordinary income. Unfortunately, it's pretty hard to qualify for this unless you actually have at least a part-time career in real estate. There are two basic requirements:
- You have to work in real estate at least 750 hours a year (that's basically almost half-time, averaging 17 hours a week or so throughout the course of the year) AND
- You cannot do anything else more than you do real estate.
That pretty much eliminates all doctors and similar high-income professionals who are practicing full-time. However, some doctors still manage to pull this off by either getting their spouse to be a real estate professional OR transitioning out of medicine into real estate (i.e. cutting back on medicine dramatically). You can still practice medicine part-time; you just have to do real estate more.
Obviously, it's going to be a hard sell to the IRS that you spend 750 hours a year on real estate if you only own a property or two and maybe a passive syndication or a fund. When you do this, you're really making a commitment to buy +/- manage a whole bunch of properties—more if they're long-term rentals and you've hired a manager, fewer if you're doing the management yourself.
That leaves most of my readers (and me) with method No. 2 as the only option, although be aware that if your properties are short-term (an average rental of less than seven days), there is a loophole that is much easier to qualify for.
Method #2 Selling Properties (i.e. Using 1231 Losses)
This method is a little more interesting, and it takes a minute to wrap your mind around. This is especially hard to do if you understand the dogma in real estate investing to depreciate, exchange, depreciate, exchange, depreciate, die. I mean, aren't real estate investors supposed to never sell?
Well, if you're investing passively, using private syndications or funds, it can be surprisingly hard to 1031 exchange from investment to investment. Most simply don't allow you to 1031 in. So every 5-10 years, the assets are sold, and you're paid out. The key comes in what happens over the course of the investment.
In year 1, you get this big fat bonus depreciation. There may be some additional depreciation after the first year. You can't really use it all in those early years (there isn't enough income distributed), so you carry it forward. It is used to offset the income from the property over the years, so that all comes to you tax-free. However, you probably still have some left over when it comes time to sell the property in years 5-10. What is that used for? That's the key.
Many of these assets are governed by Section 1231. Section 1231 assets include:
- Section 1250 assets (depreciable buildings),
- Section 1245 assets (depreciable stuff inside of buildings), and
- Land (which you can't depreciate).
In passive real estate investing, mostly what you are getting is losses on 1250 assets. The rules on these are very different from the rules on capital gains and losses. In the capital gains/losses world you may be familiar with from your mutual fund investments, short-term losses offset short-term gains and long-term losses offset long-term gains and only $3,000 in losses can go against your ordinary income. However, the 1231 world is different. 1231 gains are taxed at the long-term capital gains (LTCG) tax rates. But 1231 losses are fully deductible as ordinary income against taxable income. Let me say that again because it is the key point.
1231 gains are taxed at LTCG rates but losses are deductible at ordinary income rates.
So, when you get to the end of your syndication's life and the property is sold, you will owe taxes on the gains. Assuming you're in the highest brackets like many syndication investors, you will pay 25% on recaptured depreciation and 20% (the long-term capital gains rate, actually 23.8% when you include PPACA tax) on any gains above that. Those taxes are the price you paid for selling the property instead of exchanging it, and in some ways, one of the prices you pay for being a passive real estate investor (the other being that you'll probably have to file a bunch of nonresident state tax returns).
But what about those losses you haven't used up? What happens to those? They're used against your ordinary income that year. Pretty cool, huh? Real estate depreciation lowers your taxes! Now, this isn't quite as cool as what you get under REPS, but it still beats a kick in the teeth—and if the REPS person sells properties instead of exchanging them, the two methods are really about equal. The losses and the gains don't even have to come on the same property. If you sell one in the same year you buy another, you can still use those losses against your ordinary income in the amount of your gains from the sold property.
Real estate investing comes with a lot of unique tax advantages. The most important is depreciation and the best way to use it is against ordinary income whenever possible. These are the two ways to do it.
What do you think? How do you use your real estate losses? Comment below!
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