1: No REPS, No Problem - Passive Loss Tax Planning For Everyone Else

Welcome to Real Estate is Taxing, where we talk about all things real estate tax and break down complex concepts into understandable, entertaining tax topics. My name is Natalie Kalady, I'm your host, and I am so excited that you've decided to join me. Hello, friends and welcome to today's episode. I am hoping that the topic for today's show. Actually comes as a bit of good news to some of you.

So this show was inspired by a comment I saw. And I've actually seen this comment pretty often from investors who have gotten this idea that unless you are a real estate professional, that you can not use losses from your rentals. I've seen multiple people respond and say, don't worry about it. If you're not real estate professional, you don't get to use the losses. Too bad. So sad. Well, this is probably a good initial mindset to have because it is a little bit more conservative, right?

It's better than expecting to be able to deduct everything and not being able to. It's also not always the case. So what I want to dive into today. Is the handful of ways that you still can use passive losses, even if you are not a real estate professional. Or even if you're not using the short-term rental loophole. So we're going to set those two things aside and today. What we're going to talk about is your everyday investor.

Who owns long-term rentals, they generate passive losses and ways you may or may not be able to use those losses.

So as a starting point. Rental income is taxed as passive income. What this means is the good side. Is that you don't pay any payroll taxes on this. You don't pay that. FICA, Medicare, social security, all of those extra taxes that you pay on your W2 income. Or that self-employment tax that you pay on your self employment income. None of those additional taxes apply to rental income.

So as a starting point, like even without looking at the benefits of depreciation and potential losses and loan paydown and everything else. Even if you are. Earning more taxable income on paper from your rentals. This is a better quality of income to have then your W2 income. The goal is to replace that earned income, which is taxed in the highest way possible. When you have those extra self-employment taxes or payroll taxes. And replace it with this passive income.

Where you are not paying those additional taxes on it. So as a starting point, just keep in mind. That if you make an extra $10,000 a year from rentals, versus if you make an extra $10,000 a year at your W2 job. You will pay less in tax on that passive rental income always. So that is the first thing to kind of put into your mind because a lot of people are disappointed if they can't use losses that happen, or if they don't have losses.

Just as a starting point, you're kind of ahead out of the gate.

The next thing to be mindful of is that while there's that huge benefit of not paying those extra taxes, The biggest downside to passive rentals. Is that to use any passive losses generated? There are some limits. So again, I've mentioned this before. There's good and bad with almost everything in the tax code. When your rental creates passive losses, the first thing to consider. Is that passive losses can always offset passive income.

So if you have two properties that cash flow really well and they make income on paper, and then you buy a new property and due to depreciation in those early years, it has a loss on paper. That passive loss can always offset passive income. Before I go farther into the episode. I want to note for anyone who is newer and listening. When we're talking about your rentals, creating a loss, creating a passive loss.

I don't want you to lose money, please don't go buy an absolutely trashed deal to lose money on for tax benefits. That is not the goal. We are not doing that. I mean, some of us, some people are doing that. They, but unintentionally. The goal is. When you buy a rental. You have all of your standard operating expenses, right? You pay. The loan interest, you pay utilities, you pay for insurance for each of those deductions that reduce your rental income. You have to write a check, right?

There's a literal cash outflow to earn that deduction.

However we get to depreciate rental properties. You get to depreciate any business use asset. This is the IRS's way of saying something you're using. That is a tangible item. Should wear out over time. Right? And you spent a big amount for this item. So we're not just going to let you write it off right now because you're really going to be using it to create income for the next however many years. So to try to better match that up. The tax code has certain lives assigned to certain asset types.

And so your purchase price, the amount you paid for the asset. Which on real estate. The amount you paid for the asset, you have to back out land. We don't get to depreciate land. So it's going to be your purchase price. Lester land value. So that asset, that tangible building asset, you get to depreciate across 27 and a half years. We're 39 years. If it's non-residential. So something I want you to think about though. Is most real estate. Is not bought in cash. Some is.

So you have to spread this deduction out across multiple years, right? 27 and a half years. If you buy a half million dollar property and let's say $400,000 of that is the building value. You likely didn't spend $400,000. You only put down. 20%, 25%. Could be as low as 0%. If you moved into it as a primary home and you had a VA loan or a two other K loan, and then you moved out later and converted it to a rental.

So the amount of cash you put in doesn't doesn't matter when it comes to this, the only thing that matters. Is the literal value of that building. The value you paid for just the building, whether it is financed by debt or cash, you get the same. Write off you get the same deduction. And this is a huge benefit. So let's say you buy a property. You finance the majority of it. And now you get to depreciate this property across 27 and a half years. Again, you paid for it with a loan.

So you didn't put this cash outflow. But now every year, You get to take that $5,000 deduction or whatever it is on paper. What this means is because you're not writing a check for it each year. At the end of the year, you have collected your rents. You have written checks for all of your operating expenses. So then let's say at the end of the year, after all of that happens in your bank account, you still have $10,000. Awesome, great. First year.

You go to file your taxes now and you get to take this extra $5,000 right off. You get to write something off that you didn't have to spend money on during the year. So in that circumstance, you would get to reduce your $10,000 of income down to only $5,000. What ends up happening a lot of the time. Is the numbers get a little closer, especially in the early years when the rental is still stabilizing.

So, what we see a lot is a rental where at the end of the year, You will have, you know, say $4,005,000 in the bank. You made a few thousand dollars on this property that is literal cash in hand. But for taxes, if you have that $5,000, write-off now that you get to write off on your tax return, but you're not actually sending off a check for. Um, for any gen Z listening, a check is like a little piece of paper. And it is like, uh, paying for something using apple pay.

But you had to kill a tree first. But any type of payment, you didn't make any type of payment to get that right off. So what ends up happening is you have an extra few thousand dollars cash in your pocket. But to the IRS, you lost money. You have a loss of a couple thousand dollars, and that is what you are taxed on. So when we talk about passive losses and having rental losses, That's the goal. That's what we're shooting for.

We're not trying to literally spend more money than we've made because spending money to save on taxes. It's typically not the move. Not early on, especially. So, what we're talking about is creating these paper losses, where you're putting more cash in your pocket. But as far as the IRS is concerned, you're losing money. That's the goal. So when you have those paper losses, these passive losses, they can always offset your passive income.

So again, if you have one profitable rental, one non that will always net out.

The next option that I think a lot of people either forget about, or they don't think about, I'm not sure. But every time I hear someone say you can only use losses. If you're a professional. That's not the case. If you meet this criteria. So there is a small taxpayer exclusion in the code. Where if your modified adjusted gross income. Is under a hundred thousand dollars. Every year, you are allowed to deduct up to $25,000 of passive losses against all of your other income types.

So if your W2 job. Is right around a hundred thousand dollars. You don't really have anything else going on. And then you have a few rentals that each lose money on paper. You can drop your income down by $25,000. The only requirement here is active participation. Which is a much lower barrier than material participation. These are separate tests and people use these terms interchangeably. They're not the same. Material participation has seven specific tests. They're harder to reach.

We talk about that more with the short-term loophole or reps. Active participation is basically just ordinary involvement, right? It's just some level of involvement. So. You have these rentals? You are actively participating. And now you can take up to $25,000 a year against your other income. If your modified adjusted gross income is under a hundred thousand dollars. No I'm saying modified, adjusted, gross income. A lot of people are familiar with AGI, your adjusted gross income.

For this calculation specifically, it's a modified version of that. There are some adjustments. Really common ones are any I'm like the deductible portion of self-employment tax gets added back. The deduction for student loan interest or tuition expense gets added back. Um, IRA contributions can be added back. So it's not just your standard adjusted gross income. So make sure you take a look at this and look at the modified, adjusted gross income calculation.

To make sure the amount is actually what you think it's going to be. 'cause some of these deductions you get for this calculation, they get put back into your income first. Before seeing if you're at that limit. So that's the first point. Check your modified, adjusted gross income. The second point, like I said, if you're under a hundred thousand, you get to take up to $25,000 a year of passive losses. And offset any of your other income with it.

Once your modified adjusted gross income is above a hundred thousand. The amount of loss, you can use it phases out by $1 for every $2 that you're above that limit. So. If your modified adjusted gross income is $125,000. Then you are over that limit by 25,000. So it phases out by $1 for every $2 that you're over. So instead of that full $25,000 loss that you can take. You're going to get half as much of that. And it's going to be 12 five. This limit and this $25,000 exclusion.

So it starts to phase out at a hundred thousand. And it completely goes away at 150,000. So if your modified adjusted gross income is over $150,000. You can no longer take any of those passive losses against your other income types. But even here. I don't want you to think to yourself. Oh, I can't use these losses. It doesn't matter. I shouldn't think about this or I shouldn't try to maximize these. Because you don't lose the losses. I've seen.

Tax preparers have kind of a blahzay attitude towards rentals and being strategic with them. With. The sort of mindset of, oh, well, their income's too high. They can't use the losses anyway. So no, we're not going to ask about if they have, you know, business use on their cell phone or no, we're not going to ask about home office, even though they have 20 properties.

They don't check and they don't think there's an intent or a purpose to maximizing that passive loss, just because the income is too high to use it in that year.

I think this is a stupid mindset because you will get to use that loss at some point. It doesn't go away. And if your income is too high. You're over that $150,000. You don't have any other passive income or even after offsetting it, there stole a loss left. What you're basically now getting to do is fund a piggy bank. You're getting to create a piggy bank to help you save tax later. Let me explain. When you have passive losses, you can't use. They don't disappear. Right?

They're not one of those pieces of paper where the invisible ink shows up and then disappears a year later. They stick around. My favorite way to describe carry over passive losses. These passive losses you can't use is if you have ever played super Mario. If you already have the raccoon tail. And you now get a large mushroom. You can't use both right. You're already the raccoon that's even better. However that mushroom just stays in that little box at the top of the screen.

It just hovers there. Waiting for when you can use it. All right. You keep going in the level. You get bit by a Kupa. Then the mushroom drops down. When you can use it. That's the same thing that happens with your passive losses. You can't use them when you incur them, but they just hang out in that little floating box until you can, and then they're there for you to use. So when can you use them? Right. I'm carrying over these losses. What's the point of the piggy bank, Natalie? Why do I care?

You can use them in any year. Your income drops below a hundred thousand. Right. Maybe you have a year you're planning to travel. Maybe you are switching jobs. Any number of things can happen in your modified income drops below that threshold. You get to start taking out some money from that piggy bank. You get to start using some of those losses. One of my favorite planning points for those losses. Is when you sell. When you sell a rental property.

The gain from that rental is in that same bucket. Of passive income, passive losses. So, if you have been accumulating these passive losses for years and years, your income was too high, you couldn't deduct them. Right. But you've been filling up your piggy bank. It's seven years in. Most investors tend to hold properties for around seven years. And maybe it's less time than that. But every few years, what I've seen with most clients is there's at least one property they want to sell.

For some reason there's just enough equity in it that the sell point versus rental break even point shifts. Maybe it's in a neighborhood where they have constantly had to evict people. There's crime there's stuff. They don't want to deal with whatever the case is. Every so many years, there's a good chance you will want to sell a property. And it's going to create a gain that is in that same passive bucket. If in that bucket, you also have a whole pile of losses.

They're going to get to offset that gain. So if you have a hundred thousand dollars of accumulated. Carry over passive losses from all of these earlier years when you couldn't deduct them. And you sell a rental property this year and it has a hundred thousand dollar gain. Those are going to get to net together. So it's a little bit shortsighted to look at rentals and think I can't use the losses. I'm not going to bother trying to maximize these.

You will get to use them at some point in almost every search circumstance. So it is always worth it to write down, to deduct, to account for all expenses that you qualify for. Even if it doesn't help you this very year. So I hate this idea that you don't get to use your losses, that unless you're a real estate professional, it doesn't benefit. You. There's a lot of benefits and there's a lot of tax planning that can come into play.

You want to make sure to be strategic and maximize those losses? Now the last thing. That I'll kind of mention.

Is people will typically say, and as a starting point, this is true. That even though you can offset your losses. You will often still have to recapture your depreciation when you sell right. If you convert a primary to a rental, but only for a few years, and you can still use a primary sale exclusion, you still have to pay and recapture or payback. The depreciation you took. Even if your gain is excluded, depreciation kind of falls into a separate little mini bucket.

We'll go into that more later. But. When you sell. People will typically say you recaptured appreciation. You always have depreciation recapture. If you just appreciated your rental on straight line. Like you didn't do a cost segregation. You just wrote it off across that 27 and a half years. What you actually have is unrecaptured 1250 tax. This is a whole other episode I'll go into, but just as a starting point. So if you're trying to look into this more, you're interested in this.

You want to research it. Unrecaptured 1250. It is any depreciation on a residential or a non-commercial building? That was not an excess of straight line. Only depreciation in excess of straight line is technically a recapture tax. If it doesn't meet that definition. Which almost no. 1250, which is depreciation on any building. Almost never does that apply anymore? The code provision that allowed that phased out years and years ago, we very rarely see 1250 recapture.

It is technically an unrecaptured 1250 gain. Is what people use the term quote, like depreciation recapture. They use a kind of interchangeably. But using the correct technical term, we'll help you. Find better guidance when you're trying to figure out strategy and planning. Right? So unrecaptured 1250 gain. And as a starting point, it is true. That you almost always need to pay that back when you sell. The reason being. Is you got that original write-off right?

Because like I said, the IRS, the tax code, they're looking at it as well. You bought a business asset, you should use it for multiple years. It will make you money for multiple years, but stuff wears out. Right? So after all these years, We're basically accounting for the wear and tear on this. And writing off the expense. In a way that matches up with the years, it'll earn you income for, and at the end of that, it shouldn't really be worth anything. That's true with a lot of assets, right?

Your computer in five years, probably not going to be worth anything. Your car, probably not worth anything. This isn't often the case with real estate, right. Real estate tends to go up. So then the IRS says, well, wait, hold, hold the phone. Hold on a second. I let you write that off because this should be wearing out. This is supposed to be worth less in 27 years, but you sold it and made more money. I want you to give me that wear and tear money back.

Because it didn't wear and tear like it didn't drop in value. So they basically want you to give them back the right off. They gave you under the assumption of something wearing out over time. So when you go to sell a rental that was depreciated on straight line. You have an unrecaptured 1250 gain. That is the depreciation recapture people refer to. You do almost always need to pay that back. However. There are a couple things you can do. To directly reduce that gain.

And this is something I don't think is spoken about enough. And if you want to know. The way that you can sell a rental. And not have to pay back the depreciation that you took and reduce your amount of that. Unrecaptured 1250 gain. Then you're going to want to come back and make sure you subscribe because one of my next episodes. Is going to cover how you can sell your rental property. And what you can do to directly reduce and even eliminate that.

1250 unrecaptured gain that quote, depreciation, recapture people talk

about. So as always, I hope you guys got some good value from today's episode. In summary. Don't get talked out of maximizing those rental losses. Don't be told you can't use them. Even if you can't use them today. You will likely be able to use them at some point and they can be a tremendous benefit to you. So I hope this was an insightful episode. I hope you guys subscribe and come back. Because you are not going to want to miss that episode.

Talking about how to reduce and potentially eliminate that unrecaptured depreciation. So I am so appreciative that you guys have stuck it out with me. Listen to the end of this episode. So subscribe share, like, and I will talk to you guys next week.