/Real Estate Losses Against Ordinary Income

Real Estate Losses Against Ordinary Income

The best way to use real estate depreciation is against ordinary income. These are the two ways to do it.

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invest in real estate it can be a risky, slow and illiquid investment. However, one of the best parts of being an equity real estate investor (at least outside of a retirement account or a REITs structure) is that you can depreciate the buildings on the property. Under current law, additional depreciation can be more than 60% of your investment in the first year. It’s amazing to invest $100,000 and get a $60,000 deduction on your taxes that same year.

Unfortunately, there is a general tax doctrine that prevents many investors from actually being able to use that deduction. It turns out that you can only use passive losses to offset passive (ie rental) income. If you don’t have any passive income, those losses simply carry over indefinitely. This is much like the long-term capital losses many of us carry for years after tax loss collection our taxable portfolio of mutual funds. Those losses offset any long-term capital gains you may have, and you can use $3,000 per year against your ordinary income. But after that, they just get transferred.

However, there are two ways to use those passive real estate losses against your ordinary income instead of waiting until you have enough rental income to use them. That is a real victory. Not only do you not have to wait years to use them, but you can use them to offset income that would normally be subject to very high taxes.

Method #1 Professional Real Estate Status

If you qualify as a real estate professional, you can use real estate losses against your ordinary income. Unfortunately, it’s pretty hard to qualify for this unless you actually have at least a part-time career in real estate. There are two basic requirements:

  1. You have to work in real estate at least 750 hours a year (that’s basically almost part time, averaging 17 hours a week over the course of the year) AND
  2. You can’t do anything but real estate.

That virtually eliminates all high-income, full-time practicing doctors and similar professionals. However, some doctors still manage to accomplish this by either making their spouse a real estate professional OR by transitioning from medicine to real estate (ie, slashing medicine). You can still practice medicine part time; you just have to do more real estate.

Obviously it’s going to be a hard sell to the IRS that you spend 750 hours a year on real estate if you only own a property or two and maybe a passive syndication or A background. When you do this, you’re really committing to buy +/- manage a lot of properties, more if they’re long-term rentals and you’ve hired a manager, less if you’re doing the management yourself. .

That leaves most of my readers (and me) with method #2 as the only option, although keep in mind that if your properties are short-term (an average rental of less than seven days), there is a loophole that it’s much easier. to qualify.

Method #2 Sale of Property (i.e. Use of 1231 Losses)

This method is a bit more interesting, and takes a minute to understand. This is especially hard to do if you understand the real estate investment dogma to depreciate, swap, depreciate, swap, depreciate, die. I mean, aren’t real estate investors supposed to never sell?

Well, if you’re investing passively, using syndications or private funds, it can be surprisingly difficult to switch 1031 from one investment to another. Most just won’t let you enter a 1031. So every 5-10 years the assets are sold and you get paid. The key is in what happens in the course of the investment.

In year 1, you get this big extra depreciation. There may be some additional depreciation after the first year. You can’t really use it all in those early years (not enough distributed revenue), so you carry it on. It is used to offset the income from the property over the years so that it all comes to you tax free. However, you will likely still have some left over when it comes time to sell the property in years 5 to 10. What is that used for? That is the key.

Many of these assets are governed by Section 1231. Section 1231 assets include:

  • Section 1250 assets (depreciable buildings),
  • Section 1245 assets (depreciable things inside buildings), and
  • Land (which cannot be depreciated).

In passive real estate investing, what you mostly get is losses on 1250 assets. The rules on these are very different from the rules on capital gains and losses. In the world of capital gains/losses you may be familiar with from your mutual fund investments, short-term losses offset short-term gains and long-term losses offset long-term gains and only $3,000 in losses may go against your ordinary income. However, the world of 1231 is different. 1231 gains are taxed at long-term capital gains (LTCG) tax rates. But 1231 losses are fully deductible as ordinary income from taxable income. Let me say that again because it’s the key point.


1231 gains are taxed at LTCG rates, but losses are deductible at ordinary income rates.

Therefore, when you reach the end of the life of your syndication and the property is sold, you will owe taxes on the proceeds. Assuming you’re in the higher brackets like many syndicated investors, you’ll pay 25% on recovered depreciation and 20% (the long-term capital gains rate, actually 23.8% when you include PPACA tax) on any profit above that. Those taxes are the price you paid to sell the property rather than trade it in, and in a way one of the prices you pay to be a passive investor in real estate (the other being that you’ll probably have to file a series of non-refundable returns). residents). state tax returns).

But what about those losses you haven’t used? What happens to those? They are used against your ordinary income for that year. Very good, huh? Real estate depreciation reduces your taxes! Now this isn’t as good as what you get with REPS, but it’s still a kick in the teeth, and if the REPS person is selling property instead of trading it, the two methods are really the same. Losses and gains don’t even have to come from the same property. If you sell one in the same year you buy another, you can still use those losses against your ordinary income in the amount of your gains from the property sold.

Real estate investing comes with many unique tax advantages. The most important is depreciation and the best way to use it is against ordinary income whenever possible. These are the two ways to do it.

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