Housing Counsel: Investor Rules of "Pigs" and "Pals"

Written by Posted On Sunday, 26 March 2006 16:00

Question: I own a small rental building (4 units), and am trying to understand the tax rules so that I can prepare my tax return. I would prefer to use one of the tax services on the internet, rather than pay for an accountant. Can you provide me with the basics?

Answer: Yes, but I still recommend that you retain a professional CPA to assist you. While many of the internet services are adequate, there still is nothing better than having a real live person to talk to -- and to hold accountable should mistakes be made. And besides, the accountant's fee is tax deductible.

There are a lot of people in the Washington metropolitan area who own investment real estate, and this includes single family homes, condominium and cooperative apartments as well as large office complexes and shopping centers.

Many people are investors by choice; they believe that real estate is a good investment. Many people are investors by default; they could not sell their family home when leaving this area, and decided to become a landlord instead.

Before Congress dramatically changed the tax laws in 1986, real estate investment was usually considered a "profit making activity." You could purchase rental property, obtain favorable mortgage financing, and receive rental income. These would often generate large "paper losses" which translated into large tax shelters.

For example, if you bought a piece of property for $200,000.00, and the land value was assessed at $95,000.00, the depreciable basis for the building was $105,000.00. Land cannot be depreciated for tax purposes. The tax laws then on the books allowed you to take accelerated depreciation, and take a large paper loss each year.

Indeed, if you decided to elect straight line depreciation, depending on what year you were in, you might have the option to depreciate the property on a basis of 18 or 19 years. Assuming that you took an 18 year basis, you could take a paper loss of $5,833 each year from your tax return ($105,000.00 divided by 18).

In addition to deducting your actual out of pocket expenses -- such as mortgage interest payments, real estate taxes, leasing commissions, advertising and repairs -- from rental income, the law also allowed you to take a paper loss called depreciation.

Congress and the Reagan administration were concerned about the growth of the tax shelter industry. Often, promoters and speculators would buy property that would not necessarily be a good investment, but would generate a significant tax write-off each and every year. These write-offs were called "tax shelters."

When Congress enacted the Tax Reform Act of 1986, it created a new concept called "passive activities." Although the primary focus of passive activity was to curtail tax shelter abuse, the net result was a dramatic impact on the average real estate investor.

Passive activity regulations are complex. Here is a very brief summary of passive activities as they relate to real estate transactions. In August of 1993, Congress modified the law for professional real estate investors.

For all practical purposes, most investment real estate transactions fall into the category of "passive activity." Oversimplified, this means that real estate losses may only be used to offset income from other real estate activities.

Prior to the 1986 Tax Reform Act, you were able to deduct your real estate losses from other income sources, such as wages and stock dividends. However, beginning 1987, this situation -- and the law -- changed.

To simplify this complex law, let us pretend that you have two buckets. One bucket is labeled "passive income generators (PIGs)" and the other bucket is labeled "passive activity losses (PALs)."

If you are involved in a real estate investment activity, all of your losses are put in the PAL bucket, and all of your gains are put in the PIG bucket. One of the primary objectives of any real estate investor is to make a lot of profit while at the same time not having to pay tax on that income.

Under the Tax Reform Act of 1986, real estate gains in the PIG bucket can only be offset by real estate losses in the PAL bucket.

There are provisions, however, for carrying forward the losses. This is referred to as "net operating loss" (NOL). You can carry forward these losses indefinitely and can use them as deductions against passive income in later years. Unused losses are allowed in full when the taxpayer disposes of the entire interest in the real estate.

There are two major exclusions from these passive activity rules:

  1. Under certain circumstances, a taxpayer may be able to deduct up to $25,000.00 of passive rental losses from other (non-passive) activities. This special rule is known as the "$25,000.00 exemption."

    To qualify for this exemption, the taxpayer must "actively participate" in the rental activity. To be an active participant, this requires "bona fide" participation by the owner of the property, such as making management decisions, approving new tenants, approving repairs or writing checks.

    However, the $25,000.00 exemption is applicable only to taxpayers whose adjusted gross income (AGI) in any taxable year is $100,000.00 or less. Where the taxpayer's AGI exceeds $100,000.00, the $25,000.00 maximum amount is phased out; the $25,000 is reduced by 50 percent of the amount by which the individual's adjusted gross income exceeds $100,000.00. In other words, if the taxpayer's AGI exceeds $150,000.00, passive losses cannot be used to offset other income.

    For married taxpayers who file separate returns and live apart, up to $12,500.00 of passive losses may be used to offset income, again with the same phasing out rules.

  2. In August of 1993, Congress reacted to the strong -- and vocal -- concerns from the real estate industry, and partially liberalized these rules in the Revenue Reconciliation Act of 1993. Now, if a taxpayer materially participates in real estate activities, he or she will be allowed to offset any losses incurred against non-passive (non-real estate) income, regardless of the AGI.

    There are two important tests to determine whether the taxpayer is eligible for these liberalized rules. First, more than 50 percent of the taxpayer's personal services during the tax year must be performed in real property trades or business. This is referred to as the "material participation" test. Second, the taxpayer must spend more than 750 hours during the tax year actively working on these real estate businesses. And the IRS has made it clear that the taxpayer cannot combine rental and non-rental activities to satisfy the test of material participation.

    However, most investors will probably still fall under the 1986 passive activity rules. You should obtain a copy of IRS Form 8582 entitled "Passive Activity Loss Limitations," which must be filed with your tax return if you claim a loss from real estate activities.

You should also obtain a copy of IRS Publication 527, entitled "Residential Rental Property." This is available on the web (irs.gov  click on "More Forms and Publications.") You can also order it from the IRS by calling (800) 829-3676.

The laws relating to investor real estate are complex; a proper understanding of these passive activity rules may provide the taxpayer some tax savings, but you are must discuss your individual situation with your own tax advisor.

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Benny L Kass

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of KASS LEGAL GROUP, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts.

Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.


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