Are You A Passive Or Active Real Estate Investor?
And How Does That Affect Your Taxes?
In the eyes of the IRS you are either an active real estate investor or a passive one. The reason for the differentiation is strictly for tax purposes. In other words, if you are an active investor (or what the IRS calls a real estate professional) the taxation rules that would apply to you are different than the rules that would apply to a passive investor.
Since Congress enacted the Tax Reform Act of 1986, in general, all real estate investment transactions are now considered passive investments. The Act introduced what are now referred to as "passive activity rules". As a result, losses arising from those passive investment activities can no longer be deducted from active income earned (salaries, wages, dividends and the like). The tax reform was enacted to deal with what was considered wide spread abuse of tax shelters at the time. Understandably, the real estate investment industry was hit hard, with many investors going bankrupt.
Prior to 1987, any losses from real estate activities could be used to offset other income, no matter how that income was earned. Now, unless you are considered a real estate professional, you can only deduct your real estate investment losses from other passive investment income (real estate investments, income from limited partnerships etc.) However, as is the case with most "rules", there are exceptions to the passive activity rules. In fact, there are two exceptions.
1. Active Real Estate Investor Or Real Estate Professional
In the Revenue Reconciliation Act of 1993, Congress "relaxed" the rules somewhat for the active real estate investor. The act allowed taxpayers who met the requirements necessary to be considered a real estate professional to bypass the passive activity rules for real estate investments in which they materially participated. In other words, an active real estate investor could now apply unlimited losses from their real estate activities against any other earned income.
The IRS defines a real estate professional as follows:
- a taxpayer who performs in excess of 750 hours of personal services during the tax year in real property trades and businesses and
- over half of her/his personal services performed during the year were in real property trades and businesses.
A further, more detailed discussion of
real estate professionals can be found here.
2. Actively Participating In A Passive Real Estate Investment
If you were just starting out in real estate investment you would not likely be considered an active real estate investor for tax purposes. Your real estate investing activities are likely serving as a second income to your main income (ie. your job). Even though this may be the case, you could still be able to qualify to deduct some of your real estate losses against your active income. Here's how.
If you actively participate in a passive rental real estate activity, you are able to deduct up to $25,000 of the loss of the activity from your non-passive income. This rule is referred to as the '$25,000 exemption'. The key determination as to whether you qualify for this exemption is whether or not you actively participated in the real estate activity. For a more in depth look at the issues surrounding this special exemption, click here.
So what happens if you cannot claim the losses? Well, pardon the pun but, not all is lost. You have two options.
- you can carry forward your losses indefinitely to use against future passive income or
- when you completely divest yourself of the interest in the real estate, you can use the losses in full to reduce your tax burden at that time.
But remember, the sooner the better when it comes to claiming the losses due to the time value of money. Every dollar in taxes that you defer the payment of, can be invested by you and earn you a return until such time that you do have to pay that dollar in tax.
The most important advice I can give you regarding this topic is to seek professional help by retaining an accountant. There are some important determinations and decisions that you will need to make and an experienced accountant will help immensely with this. And remember, the accountant's fees are tax deductible!
Of course the best way to avoid worrying about real estate losses is to avoid them altogether. In fact, the main reason I began investing in commercial property 15 years ago was the positive cash flow it provided every month and the profits (not the losses) that it generated.
If you are interested in learning more about how you can make the jump into apartment building investment, I recommend a course written by a colleague of mine that deals specifically with the ins and outs of buying your first apartment complex.
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