History

Dr. Joe is a heart surgeon and has done well for himself financially. He has an annual salary of $2,000,000. After years of investing his excess cash flow in the stock market Dr. Joe hears from a friend that if he purchases rental real estate there are large tax benefits such as depreciation he can use to lower his tax bill on his $2,000,000 salary. Dr. Joe hates paying taxes, so he goes out and purchases two rental properties. A few months later the founder of a local start up approaches Dr. Joe looking for an equity investment. The founder suggests that there will be losses in the first few years which he can deduct against his salary but after a few years the company is going to be profitable and worth a great deal more than his upfront investment.

Dr. Joe thinks he has the golden ticket. He can take the rental tax losses from interest expense and depreciation against his salary and still have cash flowing rental properties and a growing startup investment. These types of tax strategies were exceedingly popular in the 1960s and 1970s to the point where there was an entire industry of promoters who sold what became known as tax shelter syndications often involving real estate, cattle, oil and gas ventures, or equipment leasing.

Passive Activities

In the 1986 Congress squashed Dr. Joe’s entire plan with the invention of passive activities. Passive activities are typically any rental activity or a business in which the taxpayer does not materially participate. The result of the 1986 change is that losses from passive activities cannot offset non-passive income or investment income.

In one fail swoop an entire industry of manufacturing and selling tax shelters vanished due to the passive activity rules. At a high level these rules do not allow the losses from passive activities (below in red) to reduce the taxes paid on non-passive activities (below in blue) and portfolio income (below in orange).

Income Categories

Passive ActivitiesNon-Passive ActivitiesPortfolio Income
RentsSalaryInterest Income
Business (Non-Material Participation)Business (Material Participation)Capital Gains and Losses
Guaranteed PaymentsDividends
Royalties

Rents

Rental real estate is a popular investment for individuals, promising monthly cash flow and appreciation in the value of the property. Rental activities are considered passive activities regardless of the level of participation of the investor. The only way for a rental to be considered non-passive income is if the taxpayer is a real estate professional which is a high hurdle, unless real estate is your full-time work.

When a rental property is purchased, the purchase price is broken down into the underlying assets: land, building, landscaping, fixtures, etc. and deducted over the coming years. This is referred to as depreciation. The taxpayer can also deduct the interest expense on the mortgage payment, property taxes, repairs, cleaning, property management fees, insurance, etc. It is common to see these expenses exceed the rental income resulting in a tax loss. As discussed above, this loss is passive and can only reduce other passive income, it cannot reduce non-passive income or portfolio income.

Passive Business Investment

Businesses are often in need of capital and can meet this need by acquiring debt or selling equity in the company. Often businesses will invite investors to participate in the upside of the company growth by selling some of the ownership. If the business is structured as a flow-through entity such as a partnership or S-corporation and the investor does not materially participate in the business, any losses from the business cannot offset non-passive or portfolio income.

Material participation is a very specific term under the tax code. There are seven tests and if any of the seven tests are met the non-rental activity is no longer considered passive.

  1. Participates in the activity for more than 500 hours during the year.
  2. Is the only one who participates in the activity.
  3. Participates for more than 100 hours and participates more than anyone else.
  4. Participates for more than 100 hours in this activity as well as at least 4 other activities.
  5. Martially participated for any 5 years during the previous 10.
  6. Materially participated in any of the three preceding years. This only applies to personal service businesses (health, law, engineering, architecture, etc.)
  7. Based on all the facts and circumstances.

Example

In 2019 Dr. Joe purchases two rental properties and invests in Startup LLC. One of the rental properties shows a tax loss of $2,000, the second rental property shows tax income of $500. Startup LLC shows losses of $5,000. Dr. Joe has a net passive activity loss of $6,500 ($2,000 – $500 + $5,000). This $6,500 passive activity loss cannot be deducted against Dr. Joe’s salary or his portfolio income such as interest and dividends. Instead this passive activity loss is carried forward to 2020. If Dr. Joe has passive income in 2020 he can reduce that passive income by the $6,500 passive loss carry forward from 2019.

What if the two rental properties and Startup LLC continue to show losses and never show net tax income? What happens to the loss carryforwards? The only way Dr. Joe can deduct these net passive losses is to generate passive income or completely dispose of the passive activity. If Dr. Joe were to sell his entire interest in Startup LLC the cumulative passive losses would be “freed up” to be deducted against his non-passive income.

The Benefits

It might sound as if passive activities are no longer great investments due to the complexity and the inability to deduct the losses against other income, but there are some key benefits worth noting. First, passive income is not subject to self-employment or payroll taxes as earned income is. This can be a substantial tax benefit of up to 15.3% for some taxpayers. Second, the very nature of passive income is that you do not have to participate. Any source of income that does not take participation of the investor is powerful as the investor pursues their household’s financial goals. Third, there are numerous other provisions that could lead to substantial tax deductions such as the new qualified business income deduction that was created under the Tax Cuts and Jobs Act in December of 2017. These provisions vary in their applicability but when applicable can have meaningful tax savings.

Why

Investing in real estate or other business ventures can often be an emotional decision. There is a level of excitement and feeling of status that investors have toward real estate and other business ventures that is often not present with the stock market. However, it is important to step back and understand your why. Why is a real estate investment right for your household balance sheet? Understanding the true tax implications and not allowing others to pitch tax incentives as the reason to make the investment is crucial in making a wise investment, especially one that comes with complexity and is less liquid like the passive investments mentioned above.