Passive Losses – Real Estate Investing – Part 7
This is Part 7 of my Real Estate Investing Series. You can view the first 6 Parts here:
Are you planning for your Future? Real Estate Investing – Part 1
Starting at Home! Real Estate Investing – Part 2
Maintain Your Leverage! Real Estate Investing – Part 3
Picking Your Investment Property – Real Estate Investing – Part 4
Location * Location * Location – Real Estate Investing – Part 5
Cash Flow Analysis – Real Estate Investing – Part 6 A
Cash Flow Analysis – Real Estate Investing – Part 6 B
Cash Flow Analysis – Real Estate Investing – Part 6 C
Cash Flow Analysis – Real Estate Investing – Part 6 D
I want to state I am not an accountant and any information here should be reviewed with your qualified accountant for accuracy and applicability. Tax laws are always changing and your accountant can provide you with the latest information. However, the concept of Passive Losses is very important to your understanding of Real Estate Investing.
To understand Passive Losses you need to understand the Three Types of Income. The Three Types of Income are:
- ACTIVE INCOME: Active Income is money earned from your regular job and employment. This can be wages, commissions, or profits from another business.
- PORTFOLIO INCOME: Portfolio Income is income from Investments in Stocks, Bonds, Interest, and things of that nature.
- PASSIVE INCOME: Passive Income is income from an activity the taxpayer does not directly participate in. This could be a business or a partnership the taxpayer is not involved in running day to day. The IRS has also determined that this includes Rental Income even if the Taxpayer actively manages the property himself.
The IRS has determined that Real Estate Investment Loss can only be used to off set Passive Income. One of the big advantages of investing in Real Estate is writing off losses taken on the Depreciation and other expenses. This rule keeps you from taking a big loss to offset your Active Income and Portfolio Income.
However, there is an exception that allows you to use Passive Losses to offset Active Income and Portfolio Income. The exception allows the Taxpayer to use up to $25,000.00 in Passive Losses to offset Active Income and Portfolio Income. To use the exception the Taxpayer must own at least 10% of the property and it cannot be held as either a Corporation or a Limited Partnership; the Taxpayer must be active in managing the property, even if there is a property manager the Taxpayer can use the exception if he meets with the manager and takes and active part; and finally the Taxpayers Modified Adjusted Gross Income must be under $100,000.00. If the income is over $100,000.00 the exception is phased out gradually up to $150,000.00.
If you cannot use the Passive Losses then they can be carried over to future years or used as an offset against the Capital Gains when the property is sold.
This is somewhat complex, but will effect how and why you invest. If you are in a high tax bracket the passive losses can be an important tax savings. However, if you income is such that you cannot use your Passive Losses then you may want to put large amounts of capital into your investment property and reduce your interest deduction, or maybe it works for you to carry over the Passive Losses into the future.
Watch this blog for further updates in the series.
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