Passive income: Something that every investor strives for because what better income is there than income earned by doing nothing at all. Publication 925 defines passive activities as trades or businesses in which you do not materially participate in, such as businesses that you do not manage or operate yourself, investments, and real estate. Passive activity and business losses can only be deducted from your passive income. Normally, actively participating in passive businesses is cause for a reclassification from a passive to active business; however, real estate investments have exemptions.
Publication 925 states:
If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that’s disallowed is decreased and you therefore can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss. (p.4)
This $25,000 begins phaseout at a rate of $1 per every $2 of gross income you make once your income exceeds $100,000. For example, if your gross income is $130,000, $15,000 is taken away from your deduction so you are only left with a $10,000 allowable deduction. Active engagement is a lenient classification that states that you were actively engaged in the management of the business. This management can range from a variety of engagements such as approving new tenants, setting rental terms, or approving expenditures.
Here is an example taken from Publication 925 directly:
You are a single taxpayer. You have $70,000 in wages, $15,000 income from a limited partnership, a $26,000 loss from rental real estate activities in which you actively participated, and you aren’t subject to the modified adjusted gross income phaseout rule. You can use $15,000 of your $26,000 loss to offset your $15,000 passive income from the partnership. You actively participated in your rental real estate activities, so you can use the remaining $11,000 rental real estate loss to offset $11,000 of your nonpassive income (wages). (p.4)
The last exception to taking losses into your normal income would be if you qualify as a real estate professional. A real estate professional is an individual who devotes over 750 hours to their real estate properties and investments. This is the hardest qualification to meet as 750 hours requires a lot of commitment. However, a real estate professional can be either the taxpayer or their spouse. Because of this, many taxpayers elect their spouse, if they are not currently employed, to devote their time to their real estate property to qualify for this deduction. With the real estate professional deduction, 100% of your real estate losses can be carried into your nonpassive income. This offers a wide variety of tax saving strategies and benefits and is an excellent option for investors with a large real estate portfolio.
Each investor is different and depending on the amount of net income earned per year and time devoted to passive activities, different strategies can be planned and discussed. Our team of professionals at ADKF P.C. are experienced with planning, consulting, and strategizing with each client to find the best tax strategy possible.