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Issues You Should Consider Before You Invest in Real Estate

Written by Posted On Wednesday, 25 May 2005 00:00

You may think that investing in real estate is simple, but you first must decide what your investment objectives are. This is equally important for sole owners of real estate, those investing in Tenant in Common investments (TICs), and those with limited or general real estate partnerships.

Sample Investment Objective Questions:

  • Are you sheltering income and need losses to write off against it?

  • Are you building your assets with an objective to break even or generate cash flow?

  • Do you need the cash flow to live on?

  • Are you a real estate agent?

  • Are you actively involved in managing/developing your real estate assets?

To use the question of sheltering income as an example, we see that with every separate situation the tax implications are different, so you should consult with your CPA to make sure you are correctly understanding the expected tax results.

Passive Activity and Material Participation:

A passive activity is any activity involving the conduct of any trade or business in which the taxpayer doesn't materially participate. Rental activities are passive activities. Material participation requires involvement in the management or rental operations of property on a regular, continuous and substantial basis. You are considered to be materially involved if:

  1. You participate in the activity for more than 500 hours in the day to day operations during the year, or

  2. Your participation was substantially all of the participation in the activity, or

  3. You participated in the activity for more than 100 hours in the tax year and at least as much as anyone else for that year.

Participation includes making rental decisions, repairs, hiring vendors, inspecting property, reviewing financial documents, and establishing financing or refinancing.

For real estate professionals, rental real estate activities are not subject to the passive activity rules, if during the tax year:

  1. More than 50 percent of your personal services are performed in real property business in which you materially participated, and

  2. More than 750 hours are spent in real property businesses in which you materially participated.

Real property businesses are those that are actively involved in real estate development, conversion, rental, operation, management, leasing or brokerage.

Passive Losses:

Passive losses, generated by passive investments, are deductible only against passive income. Unallowed passive losses cannot be used to reduce non-passive income, like income from your work, dividends or interest unless you qualify due to low MAGI, as explained below (Unused passive losses are carried over to future years and can be used to offset future passive gains).

Modified Adjusted Gross Income (MAGI): If your MAGI is less than $100,000, it is possible to deduct passive losses up to $25,000 from rental real estate. If your MAGI is over $100,000, passive losses can be used to offset non-passive income at the rate of 50 cents for every dollar up to $150,000 of adjusted gross income. No passive losses are currently deductible when MAGI exceeds $150,000. These limitations are illustrated in the following table.

Phase-out of $25,000 Passive Activity Loss Allowance
If Your Modified MAGI isYour Passive Activity Loss Allowance is
Up to $100,000$25,000
$110,000$20,000
$120,000$15,000
$130,000$10,000
$140,000$5,000
$150,000 or more

Your MAGI is most of your non-passive income. It is the same as your adjusted gross income without including any of the following:

  • IRA contributions

  • Taxable social security benefits

  • Adoption assistance payments

  • Income from U.S. savings bonds that you used to pay higher education tuition and fees

  • Interest on qualified student loans

  • Passive activity loss in real property businesses

  • The ½ of self-employment taxes deduction

  • The tuition and fees deduction

  • Any overall loss from a publicly traded partnership

Married persons filing separate tax returns who lived together at any time during the tax year may not claim this offset on their tax returns. Married persons filing separate tax returns who lived apart at all times during the tax year are each allowed a $12,500 maximum offset for passive real estate activities.

The rules related to the deduction of losses from real estate rental activities are very complex. You should consult with your CPA when determining how those rules impact your real estate activities.

For additional information on limits on rental losses, refer to Chapter 10 of IRS Publication 17 , "Your Federal Tax Income," Publication 925 , "Passive Activity and At-Risk Rules," Publication Tax Topic 425, "Passive Activities - Losses and Credits."

References:

1. Somerset CPAs P.C. Tax letter for individuals, regarding Passive activities,
2. RealTax, Get the most from your Passive Losses, professionals/passive losses
3. Turbotax, Passive Activity loss limitations and rental properties
4.IRS Publications:

a.Publication 925, Passive Activity and At-Risk Rules
b.Form 8582, Passive Activity Loss Limitations
c.Topic 425, Passive Activities - Losses and Credits()
d. IRS publication 527, Residential Rental Property

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