By Jeffrey Dunn, principal, Fineman West
Real estate investments often show taxable losses, even though they have positive cash flows. There are also many elections and actions that investors can take to drastically increase real estate losses and reduce taxes.
By default, real estate losses are suspended and cannot be used until a property generates positive rental income or is sold. In addition, there is a 3.8 percent net investment income tax on real estate losses and gains if real estate is considered passive.
For example, a taxpayer could have a rental property with a positive cash flow of $100,000 and a taxable loss of $1 million due to depreciation or other non-cash deductions. If nothing is done, the $1 million loss is suspended and there is no immediate tax benefit.
If the rental is converted to non-passive income, then the taxpayer could use the $1 million loss immediately and possibly have $500,000 of tax savings, assuming the investor is subject to a 50 percent tax bracket. Also, if the building is converted to a non-passive rental and later sold at a $5 million profit, the investor will save the 3.8 percent net investment income tax, or $190,000.
Passive Loss Hurdle
Rental income is automatically treated as a loss from passive activity. Individual taxpayers generally cannot deduct losses from passive activities.
There are various actions taxpayers can take so that rental losses are no longer considered passive. Once the rental losses are converted to non-passive losses, they can immediately be used to reduce all other types of taxable income. In addition, if the rental losses become non-passive, the taxpayer no longer must pay the 3.8 percent net investment income tax on current rental income or on the gain when the real estate is sold.
Professional Benefits
One way to make losses non-passive is to be a real estate professional, as defined by the Internal Revenue Service (IRS). To be considered a real estate professional, a taxpayer must spend at least 750 hours during the taxable year in a real estate trade or business in which the taxpayer is at least a 5 percent owner.
These hours must account for more than half of all the taxpayer’s personal service hours during the year. If the taxpayer has a full-time job outside of real estate, it is impossible to meet this requirement. But oftentimes taxpayers will own and manage their properties with their spouses who can meet the criterion.
In addition to the 750-hour test, a taxpayer must materially participate in the operation of the rental properties.There are several tests a taxpayer can use to meet this requirement, but the most common test used by taxpayers is to show 500 material participation hours in the rental activities.
The taxpayer normally must have 500 hours in each individual property, but he or she can elect to treat all properties as one for the material participation test. If the election is not properly made, it could cause the real estate losses to be passive and non-deductible in the current year.
The 11 types of real estate trades or businesses that meet the 750-hour test are: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerage. If your only real estate business is your rental properties, you typically must own four properties to qualify as a real estate professional, depending on the facts and circumstances.
Hours counted for material participation in a rental include advertising to rent or lease the real estate, negotiating and executing leases, verifying information contained in prospective tenant applications, collecting rent, performing daily operations, maintaining and repairing the property, managing the real estate, purchasing materials and supervising employees and independent contractors.
Investor hours that do not count for the material participation test include studying and reviewing financial statements, searching for new properties, educating oneself on the business, preparing summaries of the finances or operations and managing the finances of an activity in a non-managerial capacity.
Self-Rentals
If a taxpayer rents a building that he or she owns to a business in which he or she is also an owner, the taxpayer can often treat the rental building as an active and therefore non-passive business. The rental property must make an appropriate valid grouping election and qualify as non-passive under IRS Regulations or under a past federal court case. Once the rental is non-passive, building losses are deductible against other income and the taxpayer is no longer obligated to pay the 3.8 percent net investment income tax.
Maximizing Losses and Excluding Future Gains
There are many techniques that can drastically increase losses in the current year and defer or exclude gain on the sale of real estate in future years. Some of them include:
- Cost Segregation Studies
- 100 Percent Bonus depreciation
- Section 179 Immediate Expensing
- Immediate Expensing of Leasehold Improvements Under the CARES Act
- Write-Off of Structural Components Under Tangible Property Regulations
- Carried Interests So Income is Taxed at Capital Gain Rates
- Creating Separate Real Estate Entities for Preferential Tax Rates
- Maximizing the Section 199A Qualified Business Deduction
- Section 1031 Tax-Free Exchanges
- Qualified Opportunity Zone Investments
- Structured Installment Sales
Summary
With proper planning, owners can drastically increase real estate losses and immediately deduct those losses against other income. In addition, it may be possible to avoid the 3.8 percent net investment tax on annual rental income and when the building is later sold at a gain. There are also many techniques to defer or exclude gains on the sale of real estate in future years.
— This document is intended to provide readers with general information and is not intended to provide specific tax advice. Fineman West Principal Jeffrey Dunn has more than two decades of public accounting and technical expertise with high-net-worth individuals and closely held companies. He can be reached at jdunn@fwllp.com.