Last Updated on May 22, 2021 by Alexis Gallati
Taxpayers with high ordinary incomes are highly taxed. If you’re a high-net-worth earner, you’ve likely diverted some of your income into investments. The most common investment type for those in this situation is real estate.
Passive income is taxed with a different set of rules than the ones surrounding your ordinary income. Passive income tax rates are still high, and passive losses can add to the financial burden that real estate investments creates. But passive income generators can be used to offset passive losses.
Passive Income & Losses
Passive losses are any ordinary losses stemming from a passive income-producing activity.
Passive income is any income created through an activity that you are not directly and materially involved in. Passive incomes typically come from activities that carry at least some risk. Investments of all types, including real estate, will often create passive losses. These losses can include factors such as an investment property’s depreciating value.
While depreciating value creates the impression of a bad investment, that’s not necessarily the reality. For example, a condominium you purchase may depreciate over the course of a year. But if the property has a signed lease and produces the same monthly income for years, was it really a “bad” investment?
If you find your underutilized losses building up, there are a few things you can do. It’s time to look for passive income generators that can offset your losses.
How To Calculate Your Passive Losses
Passive losses are a complex topic with several stipulations. Generally, you add up your income and expenses for the passive investment year and if your expenses exceed your income, you have a loss. You include any qualifying passive losses alongside your passive gains on IRS Form 8582. Use this form to add up the total income and loss in different passive categories, including any losses carried over from the prior year. You net the passive gains and losses together and, if you qualify to deduct those losses, these losses will be used to offset your ordinary income. However, high-net worth individuals can’t deduct these losses unless they meet certain exceptions such as the Real Estate Professional status (see more below) or having a modified adjusted gross income of less than $150,000. In this case, you need to start looking at strategies to “release” those passive losses.
Passive Income Generators
Passive Income Generators (PIGs) are investments you make that continually produce income. You can use them to offset your passive losses. But you should always do so carefully.
You can find many investments that are labeled as PIGs. Many of these investments will be in real estate. You can invest in real estate directly or through trusts.
Other PIGs include private equity funds, or other investments that don’t require you to materially participate in their income-producing activities. These kinds of investments will always be more matured, meaning they’ll be subject to less depreciation and are already producing a steady income.
Using PIGs To Offset Passive Losses
If you’ve found the right investment and weighed its risks and potential, you can kill two birds with one stone. While expanding the scope of your investments and generating more passive income, you will offset your other investment losses. You will save taxes while also increasing your earning potential.
Examples: A Few Potential Options
Invest In A Business
This is an often-overlooked option. You can always tap into real estate’s suspended passive losses to invest in another business. You don’t need to only invest in physical real estate properties.
In this case, the best investments are ones in businesses that are producing healthy net income for investors. Focus heavily on the business’s income so you can avoid creating more passive losses for yourself. After all, your goal is to offset your passive losses through a safe, income-generating investment.
To do this, you can invest in:
– Limited Liability Corporations
– Sole Proprietorships
Make sure you don’t invest in anything that would create portfolio income. Dividends and capital gains from the entities listed above are considered passive. The best part is that your income from such PIGs are not taxable up until they exceed your suspended passive losses.
If your passive losses are significant, this option gives you a lot of freedom. You can collect a lot of tax-free investment income and use that income to do with as you please. You can even re-invest it back into real estate and produce more passive losses.
On the theme of real estate, what are the better options?
Selling Investment Properties
Do you have any rental properties you’re prepared to unload? You can offset your passive losses by selling off your rental properties.
To effectively offset your passive losses, you don’t actually need to sell the real estate that’s creating those losses. Your losses will offset any passive income.
When you sell real estate, your net gains are your net selling price minus your adjusted basis. Your adjusted basis is your original basis minus depreciation. You’ll need to be able to quantify your gains…
At this point, you’ll need to determine what percentage of your gains stems from:
– Depreciation recapture
– Capital gains
This kind of accounting work is difficult and costly. But once the accounting is done, any passive losses you have can be used to offset this gain. The result is significant tax savings and the liquidation of your real estate without significant taxes.
Buy A Rental Property
One simple and great way to tap into your passive losses is to buy a property. But the key, in this case, is to focus on real estate markets with high cash flow, but low appreciation.
Properties with high rental cash flows don’t typically generate passive losses. A property that generates monthly rent-to-price ratios of 1.5% to 2% is likely to incur taxes. Even when depreciation is in the picture.
A Few Words Of Warning
We won’t advise you to invest in PIGs solely to offset losses. All investments carry risks. If you haphazardly invest to offset losses, you may find yourself creating even more losses.
While some of the methods we’ve discussed will allow you to offset passive losses now, they may incur greater expenses down the road. That’s especially true when it comes to buying turnkey properties to offset your losses. But selling a property to offset losses also has long-term ramifications.
You can also look into qualifying for Real Estate Professional Status (REPs). This turns your passive income into active income and you can take any losses against your ordinary income. See our guide on Real Estate Professional Status (REPS) to determine if you qualify as a real estate professional.
Consult A Professional
Offsetting your passive losses through PIGs is worthwhile, but difficult to execute properly.
With the right help, you can execute the ideal plan for offsetting your passive losses. A financial advisor can help balance your needs and ensure that you reach the best financial outcome. Reach out now to Cerebral to receive the guidance you need to lower your tax burden. Book at Tax Discovery Session through this link now!