Each real estate investor has a tax "status." Your status as a real estate investor is really dependent on your overall activity and what else you do in your life. 

• Passive Investor 
  • Majority of RE investors considered passive investors
  • Not involved in the day-to-day operations
• Non-Passive or Active Investor 
  • Certain classes of real estate can be "non-passive"
  • Must cross a very strict threshold to be considered a non-passive investor
  • Actively involved in the day-to-day operations

By default, every real estate investor are considered "passive" in the eyes of the IRS. The burden of proof is on the investor to prove every year that they are a non-passive (active) investor.

Passive income means ordinary income at the ordinary tax rate, but no FICA (social security) tax. For taxpayers who have W2 wages or Schedule C self-employment income, the FICA tax rate is up to 15.3%. There is no FICA taxes associated passive real estate income. 

Passive real estate income can only be offset with passive losses, and passive losses can only offset with passive income. In other words, W2 income for example cannot be offset by passive losses since the W2 income is not non-passive real estate income. 

Real Estate Goals for Any Investor: Excess Passive Losses
No matter if an investor has 1 property or 25 properties, the goal from a tax perspective is to create passive losses or "paper losses." A passive loss becomes a paper loss that will carry forward indefinitely so it can be used on future returns as tax free income. 

Part 1 of this series covered how to create passive or paper losses using strategies such as QBI deduction, accelerated depreciation, and cost segregation. The worst case scenario with paper losses is that real estate income goes down to zero which means the real estate investor will pay no income tax on the real estate income. In other words, the paper loss created tax free income.

The real home run occurs with the concept of Time Value Money and the real estate investor taking advantage of the paper losses. If a real estate investor has losses every year through depreciation, cost segregation, and business deductions on real estate property, but only shows it as a carry forward loss it's still an asset on the balance sheet for tax purposes. As discussed in Part 1 of the series, with the concept of Time Value Money, the real estate investor will want to use that loss as quickly as possible because the value of the dollar erodes over time because of inflation. The quicker the deduction can be utilized, the quicker the investor is going to be able to have more money to invest now. 

A passive investor, or someone who has a full-time job, can free up passive losses using a strategy known as a "Lazy 1031 Exchange."

Lazy 1031 Exchange

A 1031 Exchange is an option that allows active real estate investors to sell a property and defer the taxes by purchasing a “like-kind” property and rolling the funds into the new property within a certain timeframe. For properties that have very different prices, a typical 1031 Exchange may not be the way to go. The Lazy 1031 exchange allows the investor to sell a property and purchase another property, that is not "like-kind," which comes with the benefit of bonus depreciation and cost segregation. The losses from the newly purchased property can offset the gain from the property that was sold. This strategy is often misunderstood because the "character" of the gain is what matters. The gain from the property that is sold is a passive activity gain. Passive activity gains are allowed to net against passive activity losses under IRC 469.  

The Lazy 1031 Exchange enables the real state investor to realize a tax free exit from a property versus a true 1031 Exchange which is simply deferring tax. The sale of one property and the purchase of the property that will offset the gain must occur in the same year. 

Alternatively, suppose the real estate investor has several other rental properties and sells a property with a gain. The investor could instead use the losses on the other rental properties to offset the gain on the property sold. 

Example:  A property was purchased in Idaho that the real estate investor is now considering selling, but they do not want to pay taxes on the gains that will be realized. With the Lazy 1031 Exchange, the investor can use the suspended losses from other rental properties and purchase a new rental property IN THE SAME YEAR to offset the gain.  The property in Idaho is sold with a net gain of $100,000. Property #2, a rental property in Washington state, is purchased that same year for $400,000.  Utilizing a cost segregation and bonus depreciation on the new Washington property, results in approximately a $150,000 deduction in year one, ignoring everything else, all other expenses. The $100,000 passive gain will be offset by our new passive loss from the Washington property.

Invest in Passive Business Investments

As a real estate investor, investing in a friend's or family member's business as a passive limited partner can allow you to have two investments which can offset one another. One is an appreciating real estate investment with cash flow where a loss is realized. The other is investing in a friend's/family's business where money is invested, income received, but no tax paid on that income. 

• The business would have to be a flow through business where a K-1 is issued, i.e., LLC,  partnership, or S-Corp.
• Cannot be a C-Corp 

Example:  The real estate investor invests in Joe's Cold Brew coffee shop because he loves coffee and has a 5% limited partner stake. His investment was purely monetary and he has no managerial authority at all.  In year one he receives dividends every month and then receives a K-1 showing $10,000 as ordinary income. Because he did not participate in the management of that business and invested cash only, that $10,000 of passive income cash flow will offset your passive losses from his real estate investments.  He also invested in a real estate property which resulted in $10,000 of "paper" losses.  The $10,000 of income you received from your friend's business offsets the losses from that real estate because they're both like kind passive activities. The offset results in 100% tax free income. Positive $10,000 of passive income cash flow from Joe's Cold Brew Negative $10,000 in passive real estate losses This example deals with relatively small numbers, but imagine if this was $100,000 of cash flow and $100,000 of loss. Without the offset, this investor would be paying $35K on that income. This shows how investing in a passive business can make a difference!

Convert Streams of Business Income into a Passive Income Stream

Certain businesses might actually have multiple streams of revenue already existing in their business. For the real estate investor, they can look at their business activities and determine if those activities can be broken out into separate business streams in order to create passive income within their own business.  

An optometrist, for instance, has their medical service where they provide eye exams, but they may also sell glasses and other related merchandise in their storefront. These are completely different businesses: the product sales are an ancillary business of the actual medical services.

Example: A therapist, who is also a real estate investor, sells an an online course they developed as a separate revenue stream in their therapy business. In a given year, that course produces $25,000 of income to the therapist. As a real estate investor, the therapist realizes paper losses on their investment property.  The therapist can use the paper losses on the investment property to offset the income created by the online course.

These are just a few strategies for utilizing real estate investment losses to offset passive income. In Part 1 of this series we went over the big picture of real estate and how important real estate can be for your investment portfolio. We also touched on creating paper losses on real estate for tax purposes. 

Here in Part 2, we went over how a passive real estate investor can use those losses to their advantage and create tax free income. These strategies can be complex and need to be done correctly in order to pass IRS scrutiny.

Please reach out to us in Soraban if you would like to learn more about how you can utilize the strategies discussed here or if there are other topics you would like to learn more about.