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Real Estate Tax Advantage - Passive Income Offset

The IRS lumps income into three categories:

  1. portfolio;

  2. active; and

  3. passive.

Portfolio Income. The portfolio class includes income from regular investments, like stocks, bonds, and mutual funds.


Active Income. Active income includes things such as salaries and wages, independent contractor earnings, and profits on a business you own and run.


Passive Income. Passive income includes rental property income and limited partnership holdings, among other things. 


The three income groups are treated differently for tax purposes, mainly when it comes to losses. Active losses can offset any other kind of income. Portfolio losses may offset other income but only partially. The rules are more complicated for passive activity losses—and that’s where some real estate loopholes kick in.


The IRS considers rental property losses to be passive losses.As a result, rental property passive losses can only be used to offset income from other passive activities. Therefore, you can’t use them to reduce other taxable income (such as your job or stock dividends).


  • For example, if you have two rental properties, one of which earns profits while the other sustains losses, the losses from the loss-sustaining rental property can be used to reduce the profits from the profit-producing rental property. This will lower your tax bill on your overall rental property earnings.


In the event you don’t have enough passive income to absorb your passive losses, those losses are “suspended” until you can use them in future years to offset your passive income gains or reduce your capital gains in the event you sell your property for a profit.


Passive Loss Rule Exception #1: The “Active Participation” Exception


If you “actively participate” with your rental properties, you may be able to deduce $25,000 of rental real estate losses against your other income for tax purposes.


Active participation means that you own at least 10% of the property and participate in meaningful management decisions (i.e., screening tenants). The catch: your modified adjusted gross income

(“MAGI”) cannot exceed $100,000 to receive the full $25,000 deduction. At a $100,000 MAGI, the offset starts to phase out and disappears completely when MAGI hits $150,000.


Know Your MAGI


MAGI is a tax calculation that does not show up on tax return forms. However, MAGI is used to decide whether a taxpayer qualifies for special tax treatment. Your MAGI is your income after deductions.


Passive Loss Rule Exception #2: The “Real Estate Professional” Exception


If you qualify as a “real estate professional” under IRS rules, you may deduct an unlimited amount of rental losses to offset other income. This exception comes with a much higher participation hurdle (see IRS Publication 527).


To get this special exemption from the passive loss rules, you (or your spouse) have to meet both of the following requirements:


  1. spend more than half of your total working hours for the year in real estate activities, and

  2. spend more than 750 hours in real estate activities where you “materially participate” (which means you are regularly, continuously, and substantially involved).


Pro-Tip: Transform Your Rental Property


If you turn your rental property into your primary residence for at least two years, you will be eligible to shield up to $500,000 of capital gains (if you’re married; $250,000 if you’re single) from taxes.[3]


How it Works:


As long as you have owned the property for at least five years and lived there for at least two of the last five years, your property converts from an investment to a residence.


The amount you may exclude from capital gains tax depends on how long you’ve lived there.


For example, assume you bought a rental house five years ago for $300,000 and rented it for three years. Also, assume when your tenant moved out, you and your spouse moved in and stayed there for two years. You just sold the house for $400,000, a $100,000 capital gain. You can exclude two-fifths of that gain ($40,000) from taxes.


Exception:


A limitation to the exclusion under section 121 of the tax code related to “nonqualified use,” which refers to any use other than as a primary place of dwelling. In the event a homeowner wants to use section 121 on a property that has nonqualified use, the exclusion will be modified by the nonqualified use ratio. This ratio, found under section 121(b)(5)(B), is based on the time allocated to nonqualified use (the numerator) and the total time of ownership (the denominator). The resulting portion of the gain is not eligible for exclusion.


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