Strategies to Use Suspended Passive Losses from Rental Real Estate

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. 

I say phooey! 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.

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.

Related: How Real Estate Rentals Reduce Your Taxes, Even If You’re a High Earner

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.

Summary

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.

 

About Brandon Hall

As founder and CEO of The Real Estate CPA, Brandon is focused on growing a CPA firm that provides real estate clients with an awesome experience. Brandon was named 40 under 40 by CPA Practice Advisor in 2018. Brandon leverages his personal real estate investing and his Big 4 Accounting experience to offer unique insights to his clients. Brandon enjoys CrossFit and Kiteboarding when he's not crunching numbers.

21 Comments

  1. Daniel on February 25, 2017 at 6:55 pm

    Great article! Found the passive business investment section interesting. Would like to read more about ways to write off real estate losses against W-2 income.

  2. Jarrod on March 6, 2017 at 4:13 pm

    Great article, valuable info

  3. Kevin on June 15, 2017 at 2:08 pm

    Excellent article. However, my CPA conferred with a couple other CPAs and they are telling me that I can only take the suspended passive losses that were generated by the particular property that I sold. This contradicts the first paragraph under heading #2 in your article. Do you have a basis for stating that I can activate suspended losses (regardless of which property produced them) by selling any other property for a gain?

    • Brandon Hall on June 17, 2017 at 8:59 pm

      Rental real estate is a passive activity, thus when you sell the property, even though you have a capital gain, it’s also considered to be passive income. Passive income from one activity can be offset by passive losses from another activity. Thus, a gain on sale of a rental property produces passive income that can be offset by passive losses from other passive activities.

      Work through Form 8582 and the corresponding worksheets and you’ll see that this is 100% allowed. Many CPAs incorrectly cite Tax Topic 425 as their reasoning for stating that liquidation of one rental resulting in a gain does not unlock suspended passive losses from other rentals. Again, tell your advisor to work through Form 8582 (heck do it with him/her live) and you’ll see that you can indeed use suspended passive losses from other passive activities to offset the gain.

      And get a CPA that better understands real estate.

  4. Dan on July 9, 2017 at 3:03 pm

    Brandon,
    Great article! I have a pretty cool idea that a few cpas have shown interest in when I mentioned it to them although they are not as well versed on this topic as you are.
    I work for ubs as an advisor and recently came across an investment on our platform that helps soak up suspended passive losses. The investment strategy is actually tied to the aviation industry that generates passive gains.
    Having come from a smaller RIA platform I was unaware that these type of investments were available to help address this issue. The returns are actually pretty stellar with an over 20 year track record, relatively low minimums and a low correlation to the equity and bond markets.
    Happy to discuss with you if you want some color on this strategy.
    Take care,
    Dan

  5. Mark Poulton on October 28, 2017 at 12:20 am

    If I switch from being passive to a real estate professional, can I take those previous year’s passive losses on my current year at that time or are they off limits.

    • Brandon Hall on November 6, 2017 at 3:15 am

      Hi Mark – unfortunately you cannot take prior suspended passive losses in the year in which you elect RE pro. You can only take current year losses without limit.

  6. John on November 2, 2017 at 1:00 am

    The one problem I see with using suspended passive losses to offset the capital gains when the real estate is sold, as opposed to using passive income to offset the suspended losses, is you are using something that would be taxed at ordinary income rates to offset something that would be taxed at capital gains rates. Best to use PALS to offset PIGS. Do I have this correct?

    • Brandon Hall on November 6, 2017 at 3:14 am

      Yes you are correct!

  7. Leopoldo Calimbas on December 12, 2017 at 7:31 pm

    We don’t have any earned income being retired.
    I sold a rental property this year. I have a total of about $75,000 suspended PAL. But I can not use it because my loss is more than the gain without using the suspended PAL. Can I use this loss to offset ordinary income? Can I use the $75K to offset 401K conversion to Roth? Thank you.

    • Brandon Hall on December 12, 2017 at 9:33 pm

      Hi Leo – you can most likely utilize the passive losses in some manner knowing that you have a 401(k) Roth conversion. Otherwise, I wouldn’t be able to say for sure without seeing your tax returns and knowing your facts/circumstances.

  8. Steve on December 13, 2017 at 7:51 pm

    Brandon, great article! My question is similar to Leo’s. I have carryover passive losses from rentals I still own. I have recently retired and my income will drop below $100k for the first time in decades. Will I be allowed to use carryover PALs to offset earned and portfolio income up to $25k per year? Or will that only apply to income earned in the same calendar year as the passive loss accumulated, going forward?
    Many thanks!

  9. Accidental Rental on January 13, 2018 at 7:02 pm

    Hi Brandon. Awesome article! I was searching for a simple way to explain the concept to my readers for a related article. This was perfect so I had to link to it. Thanks for the great resource!

  10. Steve Junker on February 3, 2018 at 8:14 pm

    Hi Brandon, this is an outstanding article! Thank you! I was trying to understand why my tax professional zeroed out a loss on one passive loss (carried it forward) and that it did not offset the gain on another passive property for that year. Is it an income limitation or does the fact that it’s a vacation property that we use for more than 14 days limit it? Thanks again, Steve

    • Brandon Hall on February 3, 2018 at 8:21 pm

      Hi Steve – thanks for the kind words! I would be doing you a disservice if I tried to guess what the tax pro did and for what reason. Happy to take a look if you onboard as a client 🙂

  11. Tifany Ballagh on February 10, 2018 at 7:47 pm

    Thanks a lot for the blog post. Really looking forward to reading more.

  12. David on April 10, 2018 at 5:03 pm

    Hi,

    Thanks for running a great site! Quick question. I currently own 2 properties: 1 a 3 family and the 2nd a 2 family which I live in 1 of the apartments. I make 143,000 so I am only allowed a small loss. I am leaving 9,000 in losses on the table due to my higher income. Can I deduct my full mortgage interest on form a instead of half on e and half on a. This will allow a greater deduction. Thanks so much.

    • Brandon Hall on May 7, 2018 at 1:06 am

      Unfortunately you must make a reasonable allocation between personal and business use and stick to it. I’m sure there are other ways to maximize in your situation though!

  13. THOMAS GAGNON on June 22, 2018 at 9:15 pm

    Hi Brandon, this is in response to your response previously to Mark Poulton:
    His Question:
    “If I switch from being passive to a real estate professional, can I take those previous year’s passive losses on my current year at that time or are they off limits.”
    I was just researching this and was under the impression what he was requesting is possible…..

    I too am a Real Estate Professional with earned income over 150k. I previously was not a REP in an earlier tax year but this year I am. In reading IRC Pub 925 pg 3 It states:

    Treatment of former passive activities. A
    former passive activity is an activity that was a
    passive activity in any earlier tax year, but isn’t a
    passive activity in the current tax year. You can
    deduct a prior year’s unallowed loss from the
    activity up to the amount of your current year
    net income from the activity. Treat any remaining
    prior year unallowed loss like you treat any
    other passive loss.
    In addition, any prior year unallowed passive
    activity credits from a former passive activity
    offset the allocable part of your current year tax
    liability. The allocable part of your current year
    tax liability is that part of this year’s tax liability
    that‘s allocable to the current year net income
    from the former passive activity. You figure this
    after you reduce your net income from the activity
    by any prior year unallowed loss from that
    activity (but not below zero).

    How do you interpret this? It appears in my humble interpretation that activities previously passive and that are not now can consume previous passive NOLs?

    Thoughts?

    • Brandon Hall on July 23, 2018 at 8:16 pm

      This section of the Pub is just saying that prior suspended passive losses can be used to offset current year passive *income* — what you can’t do is fully utilize prior suspended passive losses when you claim RE pro.

  14. Myriam F Mourani on June 28, 2018 at 3:51 pm

    Excellent article and thank you for your insight! Question: If you own out-of-state rental properties that generated a loss (which you took on your 1040) in the first few years, can you take those losses forward on the STATE return once those properties generate income?

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