Thread by @baldridgecpa

Passive loss rules keep showing up on #RETwit

The tax shelter of real estate can be a huge savings, but losses won’t help one bit if you can’t use them.

You need to know the rules - whether you have a RE side hustle or you are a GP understanding your investors.

Thread ⬇️

https://twitter.com/laughridge/status/1330155350499217408

Tax all starts with the types of income

1. Active - income earned from Material Participation. Whether it be SMB, W-2, contract income, or prof real estate.

This is income where ordinary tax is paid and losses offset other income. Other sources have certain loss limitations.

2. Portfolio - income derived from financial instruments - dividends (including REIT), interest, royalties and capital gains.

Mostly income w/out loss potential, and favorable tax rates.

Cap losses may offset cap gains w up to 3,000 loss. Investment interest can be deductible.

3. Passive income - sec 469 defines as

1. Trade or business where taxpayer doesn’t materially participate
2. Rental activity

Passive losses may only offset passive income - not active or portfolio.

This is a problem for wage earning real estate investors.

HOW DO I GET THOSE DEDUCTIONS?

Become a Material Participant and/or an RE pro

Material Participation -
We are given a clear framework for determining Material Participation (not passive) in Pub 925

There are 7 scenarios that will get you there, and you only need to meet one.

Material participation scenarios (Pub 925):

1. 500 hours
2. Substantially all participation
3. More than 100 hours and at least 1/2
4. Significant participation
5. 5/10 years
6. Personal service activity w participation in last 3 years
7. Continuous participation.

This is great if you are talking about an SMB.

Note real estate is still considered passive unless you meet the RE Pro threshold of 750 hours and more than 1/2 your time.

This is the conundrum for passive real estate investors making a start.

If you have a full time job or large, time consuming business it can be difficult.

A huge loss from depreciation if you have one LP investment isn’t going to do anything for you. You won’t be able to deduct it..

What to do? A few ideas -

1. Acquire enough RE that it takes you or your spouse more than 750 hours a year and 1/2 your time to manage.

This is one of the paths to get to RE pro status, but it is obviously not for everyone.

2. Have your SMB buy the real estate. This can cause liability issues (consult atty..)

If your business utilizes real estate as part of ongoing operations you can get all the tax benefits of active RE.l by having the building purchase and hold the RE.

3. Build a SMB on top of your real estate (the reverse of #2) - short term rentals and high owner participation real estate businesses can have great returns.

Obviously not for you if you just want passive RE

We are in the deep end here, where each case should be judged on its own facts and merits. You should hire a professional to review your particular situation before you make an investment. It is worth it.

Re publication 925 (linked)

Before you buy a rent property or make a passive investment this is worth the read.

irs.gov/publications/p…

Note to clarify-

when you are a material participating RE pro all of your and your spouses’ RE activity becomes active, allowing you to offset RE losses against other active income.