In the Introduction, we mentioned that investing in real estate may be the last middle-class tax shelter. How does that work? After looking at cash flow after taxes, you may begin to realize that your non-cash expenses such as depreciation will cause this figure to be a negative number, or in other words, a loss. This loss may be deductible against your other income for tax purposes. Remember, this loss represents a loss on paper only. Your cash flow before tax figure represents the cash profit generated from your investment.
The IRS Rules
As you might imagine, there are some complicated rules regarding the deduction of rental real estate losses. Before 1987, any amount of rental real estate losses was deductible against income earned from any other source. People everywhere were investing in rental real estate that generated paper losses to get that tax deduction. In 1987, the IRS came up with a way to severely limit the amount of tax-deductible rental losses.
The first thing the IRS did was to divide all income and losses into three categories: active, portfolio, and passive.
The active category includes income you earn from work, such as salary, and any income you earn while conducting an active trade or business.
Portfolio income is money earned on investments, such as interest and dividend income.
The Passive category: Except for certain real estate professionals, real estate rental activities are generally considered a passive activity.
In general, the IRS says that you can only deduct the same category of losses against the same category of income. Therefore, only passive losses can be deducted against passive income. Since most people only have one rental property, there might not be any passive income from which to deduct the passive loss.
Fortunately, there is an exception to the passive loss rules. If you qualify for the exception, you can deduct up to $25,000 of rental losses against other income such as your salary or interest and dividends ($12,500 if married filing separately and you live apart from your spouse for the entire year—but if you are married and file separately and do not live apart from your spouse for the entire year, you are not eligible for this at all). As a result, rental real estate still remains a middle-class tax shelter.
Below is a step-by-step checklist that you can use to determine if you qualify for the exception:
Don't get upset if you don't meet the criteria above. The losses are not lost. Passive losses that you cannot deduct immediately are suspended and carried forward and treated as a deduction from passive activities in succeeding years. Unused losses are allowed in full when you sell the property. This means that you can deduct all the losses previously disallowed against any category of income in the year you sell the property. Any gain from the disposition of the activity would offset any loss from the activity for the tax year of the disposition. The balance of the loss would then be applied first against any net income or gain from other passive activities and then finally against non-passive income.
There are exceptions to the passive loss rule as cited above. For instance, if your spouse is an active participant in the real estate property or activity, then any real estate losses for you and your spouse are active and deductible against ordinary income. But how is active participation defined ? One way is to qualify as a real estate professional. To qualify, 1) more than one-half of the personal services performed in a taxpayer's trade or business during the tax year must involve real property in which he or she actively participates, and 2) the taxpayer must perform more than 750 hours of service during the tax year in the property in which the taxpayer (or taxpayer's spouse) materially participates; and 3) you must keep an activity log and calendar and document the hours incurred in order to substantiate your compliance with the 750 hour rule. The rules for a real estate professional are applied as if each real estate interest of the taxpayer is a separate activity; however, a taxpayer may elect to treat all interests in real estate as a single activity for purposes of satisfying the material participation requirements. If you participate in real estate you should consult your tax advisor to determine if any real estate losses are fully deductible, if you are a real estate professional, and how you might structure your real estate activities and satisfy the 750 hour rule to demonstrate active participation; you should also determine how to appropriately make the election to treat all separate real estate activities as a single activity.
SUGGESTION: Tax planning becomes an important part of your overall financial planning when you own investment property.
IMPORTANT NOTE: These passive loss rules are very complex. Call your tax professional for additional guidance or clarification.
More Tax Forms
In order to report the rental activity to Uncle Sam when you own rental property individually, the IRS requires that you file a few more tax forms to include with your Form 1040. Here is a summary of some of the forms you may be required to file and their purpose:
Schedule E—Supplemental Income and Loss
Used to report rental income and expenses for the tax year.
Form 4562—Depreciation and Amortization
Used to report depreciation expenses claimed on the rental property for the tax year.
Form 8582—Passive Activity Loss Limitations
Used to compute the amount of passive activity losses allowed for the tax year, including the cumulative amount of suspended losses that are carried forward.