Many real estate investors know of the vaunted “Real Estate Professional” status. This status is determined based upon number of hours spent participating in the real estate trade and it unlocks a number of possible tax benefits for the real estate investor.
For those investors that do not work full time in real estate, the concept of passive income and passive losses becomes important. Created by the Tax Reform Act of 1986, passive income is defined as income produced by a trade or business activity in which the taxpayer does not “materially participate.”
An investor materially participates in an activity by being involved in the operation of the activity on a regular, continuous, and substantial basis, meeting certain minimum criteria (majority of time spent in real estate trade, 750+ hours spent on the real estate and rentals). In general, for investors that do not consider their properties to be their primary activity, rental real estate business is considered passive.
While the Tax Reform Act of 1986 created these categories, it also limited the use and value of passive losses. For many taxpayers, the Act mandated that passive losses could be used only to shelter passive income – this excludes portfolio income and earned income (think stock dividends and paychecks).
This means that investors that have passive losses are leaving valuable tax-deductions on the table every tax season. For those taxpayers, passive losses may go unused and are carried forward year to year.
To take advantage of these losses, taxpayers with eligible passive activity losses (PALs) may be able to pair those losses with a passive income generating (PIG) investment. Referred to as “PIG/PAL” investing, this strategy allows an investor’s passive income to be offset by passive losses on a dollar-for-dollar basis. The passive losses shelter the passive income from taxation to produce tax-advantaged income. There is no limitation on the amount of passive income and passive losses that can be offset annually.
1. Real Estate Funds
The first option involves a real estate fund structured as a limited partnership or LLC. Unlike REITs, which generate dividends that do not qualify, LLC and LP real estate funds generate distributions that do qualify as passive income.
2. Direct Property Purchases
The second option involves the direct purchase of commercial or rental real estate. Rental income from direct property ownership is passive. Properties can be owned entirely as sole-owner, or they can be owned partially through one or more tenant-in-common (TIC) or Delaware Statutory Trust (DST) structures. Either way, the rental income generated may become tax-advantaged when off-set by the investor’s passive losses.
Form 8582 is the tax form used to reflect carry-forward passive activity losses. Your tax preparer, CPA, or tax advisor can help you locate this part of your tax return.
If you or your clients are looking for access to PIG investments, or have a need for 1031, Opportunity Zone, or other tax-advantaged real estate strategies, please reach out to our team, or register to peruse our DST property listings.
* Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Examples are for illustration purpose only – individual circumstances may vary