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PAL 01: An Overview of Passive Activity Rules for Real Estate Investors

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In this episode, Brandon and Thomas discuss the passive activity rules and how real estate investors can take advantage of them to minimize, and even eliminate taxes on their rentals and passive business activities.

This episode is sponsored by Landlord Studio and Tax Smart Investors.


Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.

Thomas Castelli 0:00
You're now listening to the real estate CPA podcast. Your source for all things real estate, accounting

Brandon Hall 0:05
and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.

Thomas Castelli 0:29
We all know minimizing taxes is essential to grow your portfolio However, another important aspect of growing your portfolio is making sure you have the right accounting system in place. And while there are plenty of general business accounting software options out there. They're not designed for landlords managing rental properties and can feel clunky and overly complex. Landlord studio on the other hand, is designed specifically for Do It Yourself landlords, they offer a full suite of tools designed to help landlords save time with their income and expense tracking, as well as property management tasks like rent collection, rental listings, lease management and tenant screening. One thing I found particularly impressive was its ability to connect bank accounts to view and reconcile transactions from inside the software. And by using landlord studios mobile app you can digitize your receipts and the software automatically lifts and imports the receipts details. Landlords studio is also a great way to stay tax compliant, particularly as they offer a number of different financial reports including Schedule II where rental properties reported on your form 1040 You can learn more about landlord studio by heading to WW dot landlords to yo.com/cpa. Again, that's landlords to do.com/cpa We'll drop that link in the show notes below. But for now we'll jump right into today's episode. Hey everyone, thanks for tuning into this episode of The Real Estate CPA podcast. I'm your host Brandon Hall and Thomas Castelli here and we're kicking off a nother series is going to be the passive investor series. So this is for real estate investors who commonly invest in passive investments such as syndicates. And that's going to be whether it's multifamily self storage, mobile, home parks, office buildings, ATM machines, businesses, we're going to cover all that within the series. This is the first episode, we're going to give you an overview of what that looks like for you.

Brandon Hall 2:09
Alright, so the first thing that we want to get straight with everybody is the passive activity loss rules, right, and we've talked about the passive activity loss rules over and over and over, so I'll keep it short. But if you want to learn more about passive activity loss rules, go check out our reps, our EPS, or the STR series. So you can find those by just scrolling down our podcast episode list in Apple, iTunes, Spotify, whatever you're using, and just look for the literally the letters are EPS or STR at the beginning of the title of the episode, that you know you'll you're in a series of episodes at that point, just much like we're in a series right now. So this is the first of several episodes that we're going to be recording on investing passively as like an LP into different funds and deals. So passive activity loss rules, when you invest passively in well, really, it doesn't matter. I mean, running a business or investing passively, you're always subjected to the passive activity loss rules, you have to meet a series of tests to determine whether or not you are passively involved, or whether or not you are non passively involved in and a lot of people sub in the word active. But I like to use the actual terminology in the Internal Revenue Code. And it says non passive. So you're either passive or you're non passive, right, you've got two buckets of income, you're non passive in your W two job, I'm running a business, Tom's actually running this business with me partner. So we are both non passive in the CPA firm that we run. Okay, so that goes into that non passive bucket of income, but on my real estate investments that I have my beach home, I, maybe not, maybe we'll see if I can get the STR qualifications on that. But my rental real estate that I own, I'm passive. I'm passively involved in that, right, the limited partnership investments that I've made, that Tom has made, we're passively involved in those. So that all goes into my passive bucket of income, it's a separate bucket of income from the CPA firm income that we have. And because it's in that separate bucket of income, any losses that are created from those passive activities, they can't jump out the losses, don't jump out of the passive bucket and offset my income in my non passive bucket. Okay, so I can't go and invest in like, in a real estate deal, or an ATM Syndicate, which we'll talk about or a self storage Syndicate, or a hair salon, or whatever it is, I can't go and invest in these things, whether or not it's a fun, a syndicate or private investment that I'm making with friends. If I'm not materially participating, if I'm not involved in the day to day, making decisions, having voting rights, like all these things, if I'm not really involved in the activity that I'm investing in, then what's coming back to me is passive income or passive losses, and it's going to be stuck in that passive bucket meaning that if I have passive losses coming back to me, they can only offset it Come in that passive bucket. And if I don't have any income in that passive bucket, then the passive losses become suspended, because they can't jump out and offset my non passive income. With a couple of exceptions, there are a couple exceptions to that rule. But in general, they get suspended, and they get carried forward, they get carried forward until I die. So you don't lose them. You can use them at some point. But you can't go in like, we're going to talk about some of the marketing schemes that these syndicators, these deal makers use to kind of like, a lot of people talk about the tax benefits of investing in their deals in you have to understand that, yes, it's a tax efficient deal. But it's not going to necessarily allow you to go and offset all of your other income that you earn. Because you're passively investing in these things, your losses are going to be locked up in the passive activity loss bucket, that passive loss bucket, or the passive income bucket and your other income is in the non passive bucket. You can't jump your losses out unless you qualify as a real estate professional, or unless you dispose the activity. So just be aware that those rules exist. That's where I wanted to start this entire thing is that you just can't go in thinking that this is going to provide me with amazing tax benefits, unless you're going to qualify for one of those exceptions to jump your losses out of the passive bucket and into the non passive bucket. Right. Yeah, there's

Thomas Castelli 6:22
a lot of syndicators out there to your point that will promote the tax benefits of it. But just know that if you have a full time w two job or your full time and another trade or business, that's not real estate, and if you're investing into a limited partnership interest, whether it be multifamily commercial, self storage, office buildings, what have you, and you're investing as a limited partner, very likely, it's going to be considered passive, because you're not materially participating in those activities, by definition of being a limited partner, the general partners, the people actually, you know, running the deal day to day, those are the people who are going to be materially participating, and not you. Yeah, right.

Brandon Hall 7:01
And it's important to remember too, that like, there are still tax benefits. I mean, right, you still get all the tax benefits, right? You just, it would be like going and owning your own rental property, that rental property, guess what, it's passive too, unless you qualify as a real estate professional and materially participates, that rental property is subject to the same rules. If you create a loss on your rentals, it's also stuck in the passive bucket. And that loss will also be suspended and carried forward if you don't have any other passive income, and if you don't suppose the activity, so when you're investing in big deals, you're getting the same treatment tax wise, it's just now you have a little slice of a large deal of a large property. So same treatment, just different sort of a form, I guess. So when the syndicators when the general partners these deals, when they're putting together the deals, and they talk about the tax benefits, they're not wrong, there are tax benefits, that's my point, this whole thing, like you're still investing in real estate, assuming that you're investing in real estate, you're still investing in real estate, which is going to provide amazing tax benefits. So let's say I put $100,000 into a big apartment complex building that they're raising millions of dollars for. So I put $100,000 into it, I get a small slice. And let's say at the end of the year, my k one shows a $90,000 loss. Now this $90,000 loss on my k one is not hopefully but most likely not from operations, it's not an operating loss. It's a loss because the syndication, did a cost segregation study the accelerated depreciation which is a non cash expense, okay? So they allocated the created this huge loss for the syndication the entire deal. And they allocated $90,000 to me. So I put $100,000 in, I get a $90,000 loss pass back to me, that loss is passive. I don't have other passive income. If I haven't sold a passive activity, then that $90,000 tax loss is suspended on my tax returns, you can find this suspension on form 8582 8582. And your tax returns. It's suspended there, and it's carried forward year after year after year. And you might go oh, there's no tax benefits for me. This is phooey. But next year, when they pass $10,000 of income to me, that's what my k one shows $10,000 of allocated income. Guess what, that's passive income. Passive income can be offset by suspended passive losses. So now I have this $90,000 that I carried forward. It eats into that or that 10k of income that I just received, eats into that 90k loss. And next year, I carry forward an $80,000 loss when they sell it that next year, and they allocate $100,000 gain to me, total gain including depreciation recapture, then I have this $80,000 Suspended loss that I get to use to offset that 100k games now I only have a net 20k gain that I have to pay tax on. So still tax benefits, but if somebody is telling you that they're going to pass losses by Back to you. And you're gonna be able to use those losses to offset your W two income, your business income, etc, etc, you should be very, very careful one accepting that as gospel because it's not going to be true, but to also investing in with that person because somebody is telling them that their support teams telling them that which means that their support team doesn't know what they're doing right? Their CPA is saying yeah, if you go and build this ATM Syndicate, then all of your limited partners are going to get these massive tax losses because an ATM is what five, seven year property, it's one of those five or seven year properties. So if I buy a $5,000 ATM, I get a $5,000 tax deduction the year that I buy it, thanks to 100% bonus depreciation. Now, if I'm passively investing in an ATM Syndicate, great, they're gonna give me these massive losses. But I still can't use those losses to offset my w two income on my business income because the losses are stuck in that passive bucket, right? So I can't jump my losses from the passive bucket to the non passive bucket. In order to do that I would have to materially participate in the deal in the actual deal itself in the company, whatever. But if I'm just an LP, I'm just putting money up and I'm sitting back and collecting checks. It's not going to happen if I buy ATMs. I know that we're stuck on ATMs. I don't actually don't know why we're stuck on ATMs. But I do remember one scenario I want to talk about, let's say that, that I'm not actually investing in a fund, I'm going to own the ATM myself. Okay, so I buy this ATM, and somebody else manages it, guess what still passive. I'm not involved. I'm not materially I own the ATM, but I'm not materially participating. So it's still passive. All the losses are still passive, they're going to flow through form 8582. If I have other passive income, or if I've sold any other passive activity at a gain, I can use the losses to offset that income or that gain. But I cannot jump the losses out of the passive bucket and into the non passive bucket. Unless I am like a real estate professional materially participating in the deal, or just materially participating if it's like, in like a business, not real estate related.


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Thomas Castelli 12:08
Right, right. So I think I think kind of the bottom line here is that if you are a passive investor, really what you're looking to do is take the passive losses that you're getting from these investments, and using them either in the current year, or in future years to offset income, or capital gains, or depreciation recapture you may have from the sale of real estate or ATM machines, or whatever you're investing in, to really make sure you're not paying tax on your passive income that's generating. So really, like Brian's been saying you have backed a bucket and the passive bucket. And really, as a passive investor, like to give an example, the biggest tax planning tool we see about around this is, let's say that it's 2022, right, and you're expecting you invested in a syndicate or maybe you invested in a property that you have that you're selling, and you're gonna have a game, that game is going to be in the passive bucket because it's a passive activity, what you can do is you can invest in a syndicate an ATM machine, or another business where you're going to be in a limited partner position, those losses that you may get from making that investment in 2022, are also going to be passive. And they can help you offset the gain from the sale of that rental property you have or from the syndicate that sells a rental property in the same year. So that's kind of the scenario you'll want to be looking at as a passive investors, how can I use passive losses to offset my passive income? So that's, that's the strategy there,

Brandon Hall 13:32
right, and you've got some layering, too. That's the beauty of being a limited partner, you can layer your investments. And what do I mean by that? Well, let's say in 2021, you put $100,000 into a syndicate, you got a $90,000 loss passed back to you, now you have a $90,000 Suspended passive loss in your tax returns. Because you don't have other passive income, you didn't sell anything for any sort of passive activity at a gain. So you just have this passive loss, that's your only investment. And you didn't materially participate in the deal. So you got a $90,000 passive loss that's carrying forward. Now in 2022, you put another $100,000 into a deal, you get another $90,000 passed back to you 2023 You put another $100,000 into a deal, maybe you get $85,000 passed back to you because bonus depreciation starts to phase out and 2023 2024 you put another $100,000 in now you get $70,000 passed back to you when we had what 335 or $335,000 of total losses 2024 So we got $335,000 of total losses on our form 8582 that's carrying forward. Most people will look at that go well, that's a lot. That's not really tax optimization, but you're doing a layering strategy, you know, it's all gonna work out. 2024 he decided, You know what, I'm not going to put the next $100,000 into this deal. And your first indication liquidates and when they liquidate they allocate $150,000 gain to you. And $150,000 gain includes the depreciation recapture that you have to pay as well as the appreciation from the investment itself. You have $335,000 of total losses that's on your 8582 that had been spent and cared for. So you get to use that 335k of losses to offset the $150,000 gain from your first syndication liquidating the next year your next syndication liquids, also another $150,000 gain. So now you use the remaining $185,000 of suspended passive losses, because you already use 150k the prior year. So you got 185 left use that now you have $35,000 of suspended passive losses left, but you still have what three deals two deals that you've invested in the next deal liquidates, $150,000 gain again, now you have $115,000 of total gain, after you factor in your remaining suspended passive losses, you have zero suspended passive losses $115,000 of total gain, and you get to make a decision, I can either invest in another syndication in the same tax year to create another big tax loss that I can use to offset this $115,000 of total gain, or I can just take a tax it on 115k of total gain. So you can start layering your deals so that you don't pay taxes for a really long time. I mean, through this scenario we're talking about, it's about what a six seven year turnaround before you finally start paying taxes. So you could certainly start layering, if you're an investor, a lot of our limited partner investor clients do this where they will, you know, I've got a million dollars to invest in these limited partnership deals. Instead of investing a million dollars in December 2021, I might layer them a little bit. And the only reason I'm layering them is the timing of the future sale. You need to talk to your sponsors about when do they expect it is a five year turn 6789 The timing of that future sale, and then what these expected losses are going to be so that I can always make sure that I have losses to offset the potential sale at the end of the day.

Thomas Castelli 16:49
Right, right. And yeah, something that's important to note as a limited partner, or really as any type of investor real estate investor is that 100% bonus depreciation is going to phase out after this year after 2022. So 2023, we're only gonna have 80% bonus depreciation. So if you're expecting to have gains from syndicates in the in the coming years, it now in 2022 might be the year to make some investments to take advantage of that 100% bonus depreciation. Now, having said that, 2023 should still be pretty favorable, but it's not at 100%. So this is the last year 2022, you have to make the investments by year end 1231 2022 to really take advantage of 100% bonus depreciation if you want to use this layering strategy and start taking advantage of being able to use to bank losses now for future use. 2022 might be a year to make some of those investments.

Brandon Hall 17:43
In remember to that the passive activity loss rules, they allow you to aggregate all passive income and losses together. So you know, you can invest in rental real estate through syndications and funds. And then you can go and invest in ATM syndicate or you can invest in self storage syndicate. Or you can go to invest in your local hair salon, I was talking about hair salons, I would love to own a hair salon one day. So if anybody's out there wants to need to need the money partner on a hair salon, somebody that knows how to run a service business hit me up, I'd love to work with you potentially, but I just got my hair cut too. So some I'm feeling fresh, that's probably why. But anyway, we've got you can invest in, in local in businesses, right and don't have to be local, you can just invest in businesses as a as a money partner. As long as you're taking a like like a partnership stake, right, you can't go and invest in C corporations. And like that's not gonna work. But if you're investing in an S corporation or an LLC, or a partnership tax as an LLC, then you can have all of that flow through to form 8582, which is just where you aggregate your passive income and losses. So my rental losses, from my syndicates from the funds that I invest in from my own portfolio can offset the business income from my other investments that I make the other business investments that I make. So if I do end up, you know, buying into a hair salon or buying into a coffee shop or something like that, if I'm not materially participating, then that's all passive income, right? And it's just flowing through to me and my rental losses can offset it so it can all net out. And that's the beauty of real estate and understanding the passive activity loss rules because you can create this amazing layering this amazing netting effect without ever qualifying as a real estate professional. Everybody loves to talk about real estate professional status and we love it too. Don't get us wrong, but you know, maybe that's not in the cards for you. It's not going to be the cards for me personally because I always expect the running some sort of business and spending a lot of time doing that but I can create this beautiful netting effect to create a lot of current income and not pay taxes on it.

Thomas Castelli 19:45
Right right. Right right. So the final thing I'll say on this is that like the way you want to look at this maybe if you are full time if you have a full time w two job or you are running a business full time, it's just look at it as a way that you can increase your income without increasing your taxes because you can generate passive income in the form of rental income from syndicates and gains from the sale of those underlying properties from the syndicates while sheltering that income from taxes using passive losses. So that's probably the frame of reference you want to come from, if you are in that position where you can't be a real estate professional, because, like Brian said, I think myself, I'm not gonna be able to be a real estate professional either. So what am I doing, I'm gonna make investments into real estate, whether it be direct or into the syndicates. And just make sure that over time, I'm minimizing or eliminating my tax liability on the income and gains from those investments by using passive losses to offset that. So that's just the probably the frame again, the frame of mind you want to come into if you are in that position, where you will not be able to be a real estate professional.

Brandon Hall 20:45
So in summary, you got to understand the passive activity loss rules, just the basics. So go back, listen to our reps, our EPS podcast, listen to our STR podcast series, it'll explain the passive activity loss rules, we do a really good job of going into depth there, you got to understand the passive activity loss rules, you really need to understand that as a real estate investor anyway, just to protect yourself, and make sure that your CPA is is preparing your tax returns correctly. So you got to understand that you have to watch out for syndicators sponsors that over promise or over sell tax benefits. There are tax benefits embedded into every single real estate deal. That is true. But sometimes people will will promise things that won't actually happen whenever you go and prepare your tax returns because those passive activity loss rules apply to you. And they block you from using those passive losses. So instead, you just end up with large suspended passive losses. But that's not a bad thing, because we talked about the layering, right? So we talked about the timing. We talked about investing in syndications over multiple years, rather than just plowing it all in to one one year. And we also talked about investing in other sorts of businesses that are not necessarily real estate, ATMs, got self storage, you've got small businesses, and you could take equity profit sharing stakes in. So there's a lot of opportunity out there to create passive income. And when you can create passive income, the losses that you receive from your passive activities, whether that's a real estate syndication fund or your own rental real estate activities, the income from your passive businesses can be offset by the losses from your passive activities or passive real estate activity. So don't forget that. If you can listen to this podcast again, get that summary down, Pat, work on that year after year after year, I guarantee you 10 years from now, you're going to be creating passive income streams that you don't pay tax on, or that you should really say you don't you pay tax on it eventually, at some point, really, this is just a big tax deferment that hey, man time value of money, right? If inflation is going up this year, six to 15% based on who you talk to, I want to capture all this tax benefits today, I don't want to pay tax today, I'd rather I'd much rather pay taxes 10 years from now. So I'm going to just kick that can down the road and let inflation eat away at that eventual value that I'm gonna have to kick out of my pocket. So, so take it all in re listen to this episode if you need to, but just try to like as a limited partner as a limited investor, or as an just an investor in general, you probably really busy you probably like me and Tom, we work 60 hour weeks here at the CPA firm, sometimes more, sometimes less. But you know, we don't have a whole lot of time to try to go figure out how to take down a $10 million apartment building, I wish that we did be a lot of fun. But I can invest in that $10 million apartment building so I can get my real estate exposure. And I can get this beautiful netting effect with the passive activity loss rules, since I understand them. So I hope this helps.


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Thomas Castelli 23:39
And just to wrap up this episode, I noticed a lot of people out there still asking about the next Tech smart boot camp not 100% sure of when we're going to run the next Tech smart boot camp. But like I said last week, we had the TASH sturdy foundation course that's evergreen, it's open all the time, you can register whenever and Brennan does a great job talking about things like the real estate professional status, a passive activity rules and how you could take advantage of those for yourself short term rentals entity structuring all the fun stuff you expect to be able to build a Tax Foundation for yourself and your real estate business wherever you're going to go ahead and you could check that out by going to courses dot the real estate cpa.com and using the promo code R E CPA for $100 off again that's courses dot the real estate CPA calm and use promo code R ECPA. Get $100 off, there's no need to wait for the next bootcamp. If you want to get started today. You can go ahead and enroll in that course and get started right away and go at your own pace. So if you want to check that out, feel free. Otherwise, we'll catch you on the next episode of The Real Estate CPA podcast.

Brandon Hall 24:43
Thanks for listening to today's show. If you enjoyed the show, please find us on iTunes and leave us a review. You can also email us at contact at the real estate CPA comm with any feedback or topic suggestions, we are always taking on new clients and With the new tax laws in play, you really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs. To become a client, navigate to our client page at the real estate CPA calm and fill out a webform with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.


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