Table Of Contents
If you have a rental portfolio, there's a good chance that you have passive losses. If you're above a certain income threshold, you likely have suspended passive losses. And if you're not using a CPA well-versed in real estate taxation, you've probably been told that there's nothing you can do about these suspended passive losses.
Of course, there are ways to tap into suspended passive losses. The question is how? There's rarely any black or white when it comes to taxation, especially real estate taxation.
A suspended passive loss will occur when the investor's income (actually it's called Modified Adjusted Gross Income, but we'll keep it simple and just say "income") is too high. This is bad because we want to utilize our passive losses. We don't want to "suspend" them because it means we are leaving money on the table. The major factor for investing in real estate is to benefit tax-wise and suspending our losses erodes that benefit!
But before we dive into suspended passive losses, let's set up the foundation by discussing regular passive losses.
What is a Passive Loss?
A passive loss occurs when your rental property's expenses exceed it's income. Many people confuse a passive loss for "losing money" however it's important to make the distinction that a passive loss is for tax purposes only. This is because depreciation is a non-cash expense, meaning it doesn't cost you anything to claim depreciation each year, yet it still counts as an expense.
Here's an easy example: you have a property that you bought all cash. After all income and expenses (excluding depreciation), you made $3,000. That means $3,000 is in your pocket. When we factor depreciation in, and assuming it's $4,000, you now have a $1,000 loss (called a passive loss). However this is merely a taxable loss, not a hard loss, as you do not "pay" for the depreciation expense. You get to keep the $3,000 of net income in your pocket but you get to report a $1,000 loss on your tax return.
As you can see, passive losses aren't bad as long as they are due to depreciation. There are other instances where passive losses aren't bad, such as when you make repairs on a property and it throws you into passive loss territory (but that's beyond the scope of this article).
The problem with passive losses is that we are only allowed to claim a certain amount on our taxes each year. When your income is below $100,000, you can take up to $25,000 of passive losses. As your income increases above $100,000, the $25,000 passive loss limitation actually decreases (aka "phase out"). The rate of the "phase out" is $0.50 for every $1 increase in your income. Once your income increases above $150,000, you have been "phased out" of taking passive losses.
Related: How to Analyze a New Market
Once you are phased out of taking passive losses, any loss that occurs will become suspended. These suspended passive losses is what this article is all about. Advice surrounding suspended passive losses is what separates the great CPAs from the mediocre.
Suspended Passive Losses Can Cause Problems
Based on the prior section, we found out that if your income is above $150,000 annually, you cannot claim passive losses. If you're like some of my clients, your real estate consistently produces passive losses and your aggregate suspended passive loss balance is ever-increasing.
We don't want to see a huge amount of passive losses become suspended. We certainly do not want to see this suspended passive loss balance increase year-over-year. That's tax-free money we're leaving on the table and it effectively reduces our overall return.
However it's not all doom and gloom. By suspending passive losses, though we can't use them currently, we can use them to offset future income or gains on the sale of rental property. Smart planning regarding these suspended passive losses is worth its weight in gold. We can literally create tax-free income streams.
For instance, if you have $100,000 in suspended passive losses and we are able to figure out how to apply those passive losses, that's $100,000 less that you have to pay taxes on. Say you make $300,000 and we are able to activate the $100,000 suspended passive loss. You now pay tax as if you only earned $200,000. Total savings here would be almost $30,000!
The following are a few key strategies you can use to tap into your suspended passive losses.
#1 - Buy Better Deals
This is easier said than done but rings true. If you are consistently seeing a large amount of passive losses being thrown off by your portfolio, you should aim to buy better cash-flowing deals. Notice I'm not saying to go buy an A building in an A area as your cash flow will be much lower and likely add to your suspended passive loss. No, we want to buy B or C properties in A or B areas (properties that we have to rehab upfront). This will cause us to incur a passive loss in the first year, but that will cash flow like a king in years following, allowing us to consistently reduce our suspended passive losses.
You may also wish to invest in syndications or partnerships where the building repositioning will cause passive losses for year one and potentially year two but will cash flow like crazy going forward. Syndications are also great because hold periods are often *relatively* short, meaning that you can liquidate within 5 years and activate your suspended passive losses to wash out the gain.
Additionally, you may know I'm not a fan of Turnkey properties. Turnkey providers clearly value upfront acquisition fees over holding the properties they are selling. That doesn't make sense to me - why sell a product you don't believe in?
But turnkey properties cash flow. Not a lot, but they do cash flow. If you build out a portfolio of cash flowing Turnkey properties, the income can offset the passive losses generated by your other properties. You must be careful though and proceed with caution as many investors fail to consider capex. Your income today could be completely wiped out by a roof replacement in the future.
#2 - Sell Your Rental Property
Selling a rental property for a gain will allow you to activate any suspended passive losses regardless of which property you sell and which property actually produced the losses. This means that you can sell property A for a gain and activate the suspended losses produced by properties B, C, and D.
Determining to offload real estate is a strategic business decision. We will want to understand why you are selling and what you plan to do with the liquid cash. There are opportunity costs to every decision we make, so we want to understand what those are. We also want to evaluate every exit strategy to determine what is most viable.
When you decide to sell, you'll want to know what amount of gain you will be facing. Calculating this is beyond the scope of our article today, but it's imperative your caculations are accurate as that will directly affect the decision making process surrounding exit strategies.
When you have suspended passive losses, the liquidation decision becomes rather straightforward. If you don't have to jump through hoops of a technical exit strategy, such as 1031s, and can instead simply liquidate the property and shelter your gain, that's powerful.
#3 - Invest in a Business
Few investors, and even CPAs, understand how to tap into passive losses through means outside of real estate. Investing in a business is a great strategy to do so.
There are two key requirements to pulling this off correctly: (1) take an equity stake in a business so that you can also share in the profits; and (2) play a passive role, meaning don't be involved in the day-to-day management decisions.
The reason for meeting both of these requirements is to qualify as a passive investor as that will allow the income generated by the business to be considered passive. Passive income, as you likely know by now, offsets passive losses. Further, passive income will tap into any suspended passive losses you may have accumulated.
You must only invest in an LLC, partnership, or S-Corp. A C-Corp will not provide you with passive income as a C-Corp will pay investors out via a dividend. This dividend is considered to be portfolio income and will not offset passive losses or suspended passive losses.
Related: Have a Large 401(k)? Consider a ROBS
If you are already facing a large amount of suspended passive losses, the income generated by your private business investment will be completely tax-free up until the point that you have utilized all of your suspended passive losses. If you're really smart, you'll weave this "buying a stake in a business" strategy in with your real estate portfolio growth so that you always have a healthy income offset for the passive losses generated by the real estate.
How do you find these businesses? They are everywhere. Start by looking for local business or entrepreneur groups and put your networking hat on. Or connect with a business broker - many business brokers call these investment opportunities "PIGs" or Passive Income Generators. You'll be surprised at how many opportunities are out there.
However a word of caution is definitely in order. Small businesses historically pose more risk than established, large businesses. Be very careful and make sure you exercise full due diligence. Heck, even run a background and credit check on the owner. It can't hurt.
Lastly, if you don't see a problem getting involved in a family business, this can often be a great place to store your funds in a relatively trustworthy manner, and help a family member grow. Best of both worlds.
Bonus Preventative Strategy
All of these strategies have been centered around tapping into suspended passive losses rather than preventing them. So I'm going to throw you a bone here.
To prevent passive losses from becoming suspended, qualify as a real estate professional. In order to do so, you need to work 750 hours in a real estate activity and greater than half of your working time needs to be in that real estate activity. Once you qualify as a real estate professional, you must then demonstrate that you materially participated in your rental real estate - this generally means showing you worked 500 hours on your portfolio.
Qualifying as a real estate professional will allow you to completely write off passive losses as they occur each year while completely ignoring the limits we discussed earlier in this article. My favorite preventative strategy is to have the stay-at-home spouse participate in the rental property portfolio management and qualify as a real estate professional. This allows him/her to utilize the rental portfolio's passive losses to offset the working spouse's ordinary income, regardless of how much it is.
If there was ever a reason to get your spouse hooked on real estate, this is it.
People invest in real estate for a variety of reasons, one of those being the major tax benefits. Passive losses are one such benefit often cited yet commonly misunderstood. We work with our clients to maximize their financial and tax positions with unique strategies. It's a big picture understanding that will yield the best results.