Offsetting Income with Passive Paper Losses
We usually preach how you will receive significant paper losses in the first year of an investment with us to offset other passive income. Those losses come from accelerated depreciation. This article will dig into four ways you can use those paper losses to offset other income. We will also discuss what can be done with those losses.
Four Ways to Offset Income with Real Estate Passive Losses
1. Are you a Real Estate Professional?
Being a real estate professional is the most powerful way to use this passive loss to offset any income.
The IRS defines a real estate professional as:
1.) “More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.”
2.) “You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.”
The above definition means you must be active in real estate activities for at least 15 hours per week. As you can see, the barrier to entry as a real estate professional is high. You can also get creative; for example, doing bookkeeping for real estate ventures could count. It could also be your spouse involved as a real estate professional, which could count for both of you.
Here at JB2, as real estate professionals, we essentially never need to pay income tax because paper losses offset all of our income while still making a profit. Ultimately hitting this threshold could be possible if you are working a flexible remote job that allows you to fit in real estate hours. It’s something to consider if you regularly invest in real estate. One last caveat regarding deducting passive losses from ordinary income is that you need to be an active participant in the investment you are getting passive losses from.
2. Offsetting Other Passive Income
Often, investors use these passive losses from one property to offset income from other properties they are invested in. So ideally, you invest in at least one real estate deal a year to create new paper losses to offset passive income from other properties.
You can also use these losses to offset other passive business income you do not materially participate in. If not a real estate professional, these losses usually cannot be used to offset capital gains and dividend income. The good thing is that you carry these losses forward for 20 years, which you will find passive income to offset.
3. Opportunity Zones
Another form of investment that has gained popularity in the last few years is investing in properties in Opportunity Zones. This can be a potent tax reduction tool for investors approaching huge capital events.
What is a Qualified Opportunity Zone?
“A QOZ (Qualified Opportunity Zone) is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as QOZs if they have been nominated for that designation by a state, the District of Columbia, or a U.S. territory and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service (IRS).”-IRS website.
The two main benefits of investing in properties in opportunity zones are tax deferral/reduction of investment gains and elimination of all capital gains tax liability from future value appreciation.
Major Benefits of a QOZ
Capital Gain Reinvested into OZ Property:
Temporary deferral for up to nine years
10% reduction in tax on the gain if a property is held for at least five years
Additional 5% reduction in tax on the gain if held for at least seven years total
The reduced tax must be paid on the initial capital gains invested within these nine years.
Future Capital Gains Accrued While in OZ Property:
If held for at least ten years, gains in this property if sold are excluded from tax.
The OZ property does have a couple of significant downsides. For example, within 30 months that property needs to be substantially improved to double its adjusted tax basis. This means you need to invest in a deal that needs significant work to receive the passive loss benefit. Secondly, these opportunity zones are usually in low-income areas and may not be areas you want to invest in. This isn’t, of course, always necessarily true. In the case of JB2, we wouldn’t invest in a deal just for opportunity zone incentives, though it may allow us to be a little more aggressive on pricing while still being mindful of our standard requirements for investment.
Of course, there are other stipulations and fine print regarding these incentives that you would need to investigate yourself to confirm. Our goal here is to provide you with some high-level guidance for thought. This can be a powerful tool for someone who needs to shelter huge gains, but it’s much easier said than done at the end of the day.
4. Active Participant in Rental Property
Suppose you are an active participant in your rental properties. You may be able to deduct up to $25,000 in rental losses from ordinary income.
Active-Participant examples:
Approved repairs or capital expenditures
Found and approved tenants yourself
You must have an adjusted gross income (MAGI) of $100,000 or less to deduct the $25,000. If you are below 150k (MAGI), you can deduct some. You cannot deduct the losses against ordinary income if you are above the income threshold unless you are a real estate professional.
One Rule That Can Limit Deductible Losses
These are at-risk rules laid out by the IRS. You may be limited to losses in the amount invested in a deal. For example, if you invested $50,000, you can only deduct $50,000 in losses for that given year. Don’t forget you can always carry losses forward for 20 years.
Bringing it Together
What we shared above can be effective tax-saving mechanisms. Though we always look at these incentives as icing on the cake and focus more on returns over these benefits, being a real estate professional gives you the most flexibility to take advantage of these bonuses. It could be interesting if you have some impressive gains to shelter a well-placed opportunity zone property.
We always check to see if the properties we are looking at land in these Opportunity zones it’s a strategy we can take advantage of. Please consult your CPA and other advisors to confirm anything we have discussed before making significant investment decisions.
For educational purposes, all strategies discussed need to be reviewed with your tax professional.