22 October 2017
In my mind the primary advantage of investing in residential rental properties (over starting some other type of business enterprise) are the tax benefits. As I talk to, and prepare tax returns for, real estate investors I find that most of them are aware there are tax benefits for real estate investing, but they don’t fully understand them. One of the most misunderstood concepts I run across concerns the suspension of passive losses. I am going to explain it here for those who want to learn. There are several related concepts at work, and my goal is to explain them sequentially.
Concept 1: Passive Income
The federal government has determined there are several ways to categorize income. Two of those classifications are active and passive. In lay terms, active income is income you work for. If you have a job where your earnings are reported on a W2, that is active income. If you start a business (like PIM Tax Services) you report your income on Schedule C, and that is also active income. In addition to state and federal income taxes, you must pay Social Security and Medicare taxes on active income.
If money is rolling in from a source and you’re (generally speaking) not working for it, then it is deemed passive income. Royalty payments for writing a book or song are passive income. Distributions from a trust or a limited partnership are passive income. Rents are passive income. Now – most of the landlords I know are working pretty dang hard to keep those rents coming in. That doesn’t change the fact that rents are considered passive income. Try not to take it personally. This is actually a good thing, because passive incomes are reported on Schedule E, and you do not have to pay Social Security or Medicare taxes on passive income. That is a significant tax benefit!
Concept 2: Passive Losses
As any savvy landlord knows, it’s not terribly difficult to have a rental property that has positive cash flow for the year, but shows a paper loss on their tax return due to the depreciation expense. Losses that come from passive income generating activities are known as passive losses. In general, passive losses can only be taken to the extent of passive income. In other words, if you have $5,000 of passive income in a tax year, you can only take up to $5,000 of passive losses that year. The rest of your passive losses are suspended and carried over to the next tax year (more on that later).
I say “In general” (above) because there is an exception made for passive losses coming from residential rental properties. If you materially participate in the business of renting your property, then you can deduct up to $25,000 of your passive losses against your other (active) income. That is a really good deal if you have a rental property with losses.
As with many things in our tax code, that good deal goes away if you earn too much money. If your MAGI is above $100,000, the maximum amount of passive losses that can be taken against active income is decreased $1 for every $2 your MAGI is above $100K. (i.e. if your MAGI is $110,000, the maximum passive loss you can claim against active income is reduced by $5,000 to $20,000.) By the time you reach an MAGI of $150,000 your ability to claim passive losses against active income this tax year are gone, and all your passive losses are suspended.
Concept 3: Suspended Passive Losses
Finally, we arrive at my point! Note the terminology in use – SUSPENDED passive losses. We don’t call them forfeited passive losses. They are not forfeited, they are suspended. They can come back later. Tom Brady got suspended from the NFL for 4 games. He didn’t get kicked out of the league, he just had to take a time out. Then he came back, went to work, and won the Super Bowl. Your suspended passive losses can also bounce back.
I stress the word suspended because I frequently see landlords lament they are 'not getting any tax benefit from their rental properties' because they make too much money to claim their passive losses. They lament their lost deduction. What they really mean is they can’t claim their passive losses and get the tax benefits THIS YEAR. They did not lose anything! Those passive losses are suspended and carried forward into the future.
Sadly, I also see some tax preparers who don’t understand suspended passive losses. I’ve seen tax preparers not claim all the rental property expenses on a tax return because “the taxpayer can’t claim them anyway”. Not only is that answer ignorant, but it also demonstrates a shockingly cavalier attitude about the client’s money. The taxpayer CAN claim those losses in the future, and it is the job of a tax professional to make sure they are properly recorded.
Concept 4: Using Your Suspended Passive Losses
There are two times you tap into those suspended passive losses and put them to work for you. The first is when you have some additional passive income. Let’s say you buy another rental property and it is cash flowing very nicely. At the end of the year it is showing a profit on your tax return. Instead of paying income taxes on that profit you go into your reservoir of suspended passive losses and reduce your income from that new property. You can reduce the income all the way down to $0 if you have enough suspended passive losses to count against the new source of passive income.
The other time you can use your suspended passive losses is when you sell the property. In the year you sell the property both the MAGI limitation and the $25,000 limitation are thrown out the window. You can take all your passive losses for a property in the year you sell. That can be quite a tax break!
For example, the Smiths have a rental property that has been showing passive losses of $12,000 per year. The Smiths have an MAGI of $200,000 from active sources, so all their passive losses are suspended. After 9 years they elect to sell the property. They have accumulated $108,000 of suspended passive losses. In the year they sell the property all $108,000 of the suspended losses (plus any losses from the current year) are deducted from their income. That is going to have a significant impact on their taxes in the year of the sale!
If you don’t remember anything else from this article, remember this – you can still get tax benefits from real estate investing even if you have a high income. You may have to wait longer to realize it, but the benefits are still there. If you have any questions about this, please contact me.