In this article, I'll discuss the basics of passive activity losses. This can be a complicated topic, but I'll boil it down to its essential elements. I'll start by discussing what PALs are and where they're formed, then move on to how you can use them up in different ways, and finish up with knowing which form to use when reporting them.
Passive activity losses - these are losses (when expenses exceed income) that occur from your non-active business interests or interests in real where you don’t qualify for the small landlord exemption.
Small Landlord Exemption - Defined here. Scroll down to the “Tax Impact” section.
Where Passive Activity Losses Formed
Passive activity losses can be formed in a variety of ways. Unused passive activity losses are carried forward to future tax returns (they don’t expire). The common thread in the below examples is expenses exceeding income. Most of the time this will be because of the large depreciation benefits. I will go through three common examples.
High Income Earner With Rental Properties
High income earners that own their properties as a sole proprietor or single member LLC are subject to an income phaseout of the small landlord exemption. This phaseout begins at $100,000 and ends at $150,000. If the landlord were to make more than $150,000 in a given year in adjusted gross income, the landlord would not qualify for this exemption and all the losses would be passive.
A couple who owns three properties have an adjusted gross income of $250,000. All the real estate is in their personal name. Their tax losses from their eight unit buildings are $20,000. Since the couple is over the $150,000 threshold, they cannot take the deduction in the current year. Instead, this rolls forward each year.
Passive Investor in a Real Estate Syndication
Passive investors in real estate syndications are another good example. Please note that this only applies when the investor is using non-IRA/401(k) funds (i.e. cash in a bank or brokerage account). The passive investor (limited partner) sends their money to the active sponsor (general partners) to make the investment decision. In this instance, there is only passive involvement and there is minimal involvement once the capital is placed. All you do (in concept) is send the money and let the distributions come in.
An investor purchases $100,000 in a real estate syndication in which they are the limited partner. There is no active involvement. In year 1, the syndication losses $30,000 due to bonus depreciation. As such, there is a $30,000 passive loss.
Passive investor in a Non-Real Estate Related Business
There are instances in which opportunities are presented to people where an individual can get an equity stake in a company with minimal involvement. A good example is Shark Tank (except less dramatic). Entrepreneurs need capital for their business and hopefully someone invests. This primarily applies to passthrough entities (partnerships or S Corporations).
An investor is approached by a service company in need of capital or they will go out of business. For $250,000, the investor is able to purchase 25% of the company. In the first year the investor put in money, the company losses $100,000, of which 25% is attributable to the investor. 25% of $100,000 is a $25,000 passive loss.
How Passive Activity Losses Get Used
To reiterate, unused passive activity losses are carried forward to future tax returns (they don’t expire). There are two common ways passive activity losses are used up: (1) Upon the sale of the property or (2) being used up by passive income generators.
Sale of the Property/Investment
Upon sale of the property, your passive activity losses can be freed and written off against your active income for that specific year. What this may mean is the possibility of deducting a substantial loss. However, something to be aware of with this is if you group your real estate as one rental activity, you may not be able to deduct your passive activity losses in the year of sale. You will want to discuss with your CPA regarding your specific situation.
Further, These losses cannot be used to offset income from depreciation recapture. See my article here and scroll down to the “Sale of Property” section for further details to learn more about depreciation recapture.
Example 1 (Continued from above): Sale of property
Assume the couple has held onto the eight unit building for 10 years (and this is their only building). Over these 10 years, they have accumulated losses of $100,000. During the year, they sold the building and made income from their W-2 jobs of $300,000. This would reduce their income by $100,000. As such, they would be paying tax on the $200,000 instead of the full $300,000. There would be further tax consequences such as capital gains and depreciation recapture for the sale of property. That is outside the scope of this article.
Passive Income Generators
Passive income generators are businesses and/or properties that you are not actively involved in that produce positive taxable income. Should you have passive activity losses from other sources, you may deduct them from the passive income generators.
An investor has a W-2 job that pays $200,000 per year. This investor also owns six free and clear houses that produce a combined positive taxable income of $50,000 (considered passive). During the year, the investor determined that they wanted to be involved in a real estate syndication. The investor put in $100,000. When the investor received their K-1 form (showing their activity in the partnership for the year), they were pleasantly surprised that they lost $40,000. This meant that the $50,000 produced from the six houses was partially offset by the $40,000 in loss from the partnership. The total amount of taxable income from their passive business was $10,000.
The correct form to report passive activity losses on is form 8582. For the purposes of this article, we will not go through the mechanics and intricate details of this form. Should you want to have some phenomenal night time reading, you can read the instructions for form 8582.
Putting It All Together
Passive losses can be formed in a variety of ways whether it be through making too much income to qualify for the small landlord exemption, investing in a syndication as a limited partner, or investing in private businesses. Ultimately, these passive losses are rolled forward and generally don’t expire until you either have disposed of the activity/asset or have income coming in from other passive sources to offset the losses. My hope is that this article aids in your understanding of passive losses, an often tricky area of the tax code.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at firstname.lastname@example.org.
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