The rental real estate market is currently experiencing a period of flux. While certain areas are still seeing strong demand and rising rents, others are facing softening markets with erratic price behavior and an increase in vacancies. These trends can leave many property owners grappling with unexpected operating losses. Fear not, landlords: Even in a challenging market, there's a silver lining — the potential for strategic tax benefits through passive loss rules. 

Let's delve into the world of passive loss rules and explore how time spent on proactive tax planning can turn a temporary setback into a long-term advantage for your rental property portfolio. 

Demystifying the Maze: Understanding IRS Passive Loss Rules 

The IRS generally considers rental properties as "passive activities." There are exceptions for real estate professionals who materially participate in the business operations of those properties, as well as for some business owners under qualifying "self-rental" arrangements. Both exceptions have a number of qualifiers, and require time-sensitive tax elections, which is why early planning is so critical. If you don't meet an exception, losses generated from your rental operations can't be used to directly offset your income from wages, investments, or other non-passive sources. You can find a more detailed explanation on the IRS website: https://www.irs.gov/taxtopics/tc425. 

If you don't qualify for an exception, this might seem like a dead end at first glance. But there's another crucial detail to consider: Passive losses can be used to offset passive income. Passive income refers to earnings from ventures where you don't materially participate in the business. This includes income from other rental properties, some partnerships and S-corporations, or certain types of investments. 

Here's why this is important: Using your passive losses in the year they're incurred helps reduce your tax bill at the time when cash is likely a significant constraint. If the losses can't be used in the current year, they are carried forward to offset future passive income.  

In simpler terms, passive losses can act as a shield, reducing the tax impact due to income from other profitable passive activities.  

Turning Losses into Advantages: Tax Planning Strategies for Rental Property Owners 

While the IRS passive loss rules might seem like a hurdle at first, after comprehensive tax planning with a qualified tax professional, passive loss rules can work to your advantage. Here are two key strategies to consider:

Embracing the Carryover:

When passive losses exceed passive income in a given tax year, the excess losses can be carried forward to future tax years. These losses can be used to offset future passive income, thereby reducing taxes in subsequent years.  

Do you have a rental property you have been avoiding selling because of the massive tax bill you might receive on the gain? Or do you expect a significant income realization event in a future year? Using passive loss carryovers from the current year can help offset the high-bracket income that you expect to be generated by these future events. 

There are a couple different ways this can look. If your future income event results in passive income, the carryovers will automatically offset the income. However, if your income event is not passive income, the "passive activity" would need to be fully disposed in order to allow the loss to be used.  

Consider a taxpayer, Sally, who has held a rental for 10 years, with a $1 million passive loss carryover. Sally expects to receive a $1 million incentive bonus in 2025, which will be taxed at high ordinary income rates. If Sally sells her rental property during 2025, the passive loss can be deducted against the ordinary income. While there will likely be a gain on the property sale, much of it will be taxed at rates lower than those applicable to ordinary income. Further, if Sally also has a brokerage account and has followed a capital loss harvesting strategy, the capital loss carryovers may be able to offset some or all of the gain on the property sale.  

Maximizing Passive Income Classification:

As a rental property owner, if your holdings are set up in a way that generates a significant amount of passive losses, with little ability to deduct them against your non-passive income, you may be wondering what options are available. Fortunately, there are multiple avenues to deducting your passive losses, and the best one for you is dependent on your plans and goals.  

One such option, as mentioned above, is to sell the activity that generated the losses. This allows the carryover to lose its "passive" taint. However, not everyone wants to sell their rental just to change their tax result. Further, a sale might generate a significant amount of taxable gain which, if not properly offset by capital loss carryovers, could defeat the purpose altogether. And a §1031 exchange does not qualify as an "entire disposal" of the passive activity and thus does not unlock those carryovers.  

Another option is to structure your real estate holdings in a way that produces passive income commensurate with your passive losses. For example, if you have a leveraged rental portfolio generating passive losses due to large interest and depreciation deductions, but you have assets generating interest and dividends (which don't qualify as passive income), the latter could be re-deployed in activities that produce passive income.  

If selling and re-deploying assets isn't part of your near-term plan, there still may be another option. If you own an interest in a business in which you are a material participant, changing your level of activity could be enough to change the tax treatment of the income. Reducing your level of activity below the material participation thresholds found in the passive activity regulations can cause the income from the business to be considered passive, thus allowing it to be offset by the loss carryforwards. Note that some of the thresholds require a multi-year look, so this strategy often takes time to begin to work.  

The IRS passive activity rules contain several nuances and take unexpected turns. The results can also be influenced by seemingly unrelated components of your tax situation, so they should be carefully considered with a tax professional who knows this area of tax law and has visibility to your full financial picture.  

Contact Us with Questions 

Whether your losses were generated by tax-aware investing or are due to a challenging market, you want to ensure that they do as much as they can to reduce your tax burden. Delap has a team of tax professionals and wealth advisors with expertise in managing passive losses and maximizing tax savings for rental property owners. Please reach out if you have any questions or would like assistance in developing a comprehensive financial strategy to minimize future taxes. 

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