Over the course of the first six months, we have talked about many types of income and deductions. Income items like wages, dividends, interest, etc. are familiar to many of us and relatively easy to determine. The same is true of home mortgage interest, charitable contributions and other itemized deductions.
But if you don't have the great tax gods in the sky helping you, trying to make sense of rental, royalties and pass-through type income and loss can literally drive you crazy. Let's take an example familiar to many people - rental of a house that was previously your principal home. Presently, the housing and rental markets are fairly good, so many people are actually experiencing positive cash flow, but let's assume the housing market is bad and you lost $25,000 on the property, excluding depreciation.
This was an actual cash loss that didn't even take mortgage principal payments into account, so you would think that perhaps this was a deductible loss. Your thinking makes sense, but the provisions relating to rental income do not operate on logical rules. Before you can take that loss, you need to answer several questions that we will discuss in the following paragraphs.
First, you need to understand that income or loss on rental real estate is, by definition, what the Internal Revenue Code calls a "passive activity." Shoot, you really don't do anything but collect the rent and maybe you sometimes make repairs or other major decisions, but by and large, you aren't considered to be "earning" the income or loss. As a passive activity, there are a bunch of tests you have to meet if you want to deduct rental losses or utilize rental income.
Rule One - Take a look at your adjusted gross income. If your adjusted gross income is less than or equal to $100,000 ($50,000 for single filers and heads-of-household), you are home free. Take the deduction and head for the post office to mail that return. Oh, did we forget to tell you there is one little problem? The term "adjusted gross income" does not simply refer to line 34 or line 35 of your Form 1040. No, you have to take out any social security income and add back certain exclusions from your regular taxable income.
For example, assume you have adjusted gross income of $100,000, but that includes a deduction of $25,000 for the real estate loss. You must first add back the $25,000 to get your modified adjusted gross income and also $6,733 in the self-employment tax deduction you took. After the calculations, you actually only get to deduct $21,634. Ah, well, at least you get to deduct most of the loss; that is, if you qualify under the active participation in rental real estate rules. We won't try to explain those to you, but what you were doing in our example above would probably qualify.
Oh, by the way, if you make $150,000 ($75,000 for single filers and heads-of-household), youÂ’re out of luck; pull the checkbook out.
Rule Two - "Hey," you protest, "I am a real estate broker with rental properties on the side. Can I deduct the losses on one partnership or property against properties that make money?"
Now you know why we write this column, because you're smart and ask smart questions. The good news is you are in luck. If you are a real estate professional, you may be able to label those activities as "nonpassive," in which case, you can deduct the full amount of any losses. There are, of course, rules to follow. To simplify the discussion, over half of your personal services performed in the year must be in real estate businesses where you or your spouse materially participate and you must spend at least 750 hours a year in the real estate business on an annual basis.
If you don't meet this requirement, hope that you meet Rule One. $25,000 is a lot of money to lose and get no current deduction.
Rule Three - Just because your passive losses come through partnerships that make money, don't think your losses are fully deductible. Say you are in a partnership that has $50,000 in "trade-or-business" income, $10,000 in interest income and $25,000 in passive losses. One of the quirky rules in tax law is that you cannot deduct passive losses against "active" trade or business income nor can you deduct it against "portfolio" income. Interest and dividends are portfolio income. Unless you have other passive income, you canÂ’t take the deduction. The good news is unused deductions can be carried forward until you dispose of the activity.
Rule Four - You cannot turn trade or business income into passive income in order to deduct passive losses. At the outset of the passive activity rules, many closely held businesses sold their business properties to the shareholders or owners. In turn, the owners would rent the property back to the business. The theory was that people could take the income generated by the building rental to the business and deduct passive losses against that income; thus avoiding building up unused deductions. All we can say is thatÂ’s not going to work on audit. The IRS has squarely rejected that maneuver.
Recap - So, you see, Congress used the "passive" activity rules to aggressively connect itself with a new source of revenue at the time the rules were enacted. When it did so, it created a complicated set of rules that continue to grow more complicated. If you are contemplating transactions involving passive activities, which are not limited to rental real estate, step back, take a deep breath before jumping and give your CPA a call to discuss the tax aspects of the deal. If you don't have a CPA, give us a call and we will be glad to recommend someone (in our office).