Nonpassive Losses: Nonpassive losses are deductions that can offset other income types, such as wages, dividends, or business income. 
In real estate, nonpassive losses can be generated when a taxpayer qualifies as a real estate professional, a self rental as a business owner with a grouping election or through activities like short-term rentals where they materially participate.

Cost Segregation Study: A cost segregation study breaks down the components of a property into different depreciation classes, allowing for accelerated depreciation. This results in substantial upfront deductions, especially when bonus depreciation is available.  Check out our other videos on Cost Segregation Studies. 

Roth Conversion: A Roth conversion involves transferring funds from a traditional IRA to a Roth IRA. The converted amount is added to the taxpayer’s ordinary income for the year, potentially resulting in a significant tax liability. However, if offset by nonpassive losses, the tax impact can be minimized or eliminated.  This not only creates tax efficiency TODAY but reduces or eliminates the deaded RMDs in retirement and balances you "buckets" of retirement income (see our Power of 0 Webinar). 

Example Scenario: Short-Term Rental and Roth Conversion

Example Details:

• Purchase Price: $800,000 (building basis)
• Short-Term Rental: Actively managed, qualifying for nonpassive treatment (100 hours and more than anyone else)
• Cost Segregation Analysis: Identifies 25% of the basis as eligible for bonus depreciation
• Bonus Depreciation Rate: 60%

The Anomaly Team lets you know there is a $120,000 is a nonpassive loss that can offset other ordinary income.

Calculate the Tax Impact of the Roth Conversion:

• Traditional IRA Conversion Amount: $120,000 = Income
• Tax Impact: The taxable income from the Roth conversion is offset by the $120,000 nonpassive loss, potentially resulting in no additional tax liability from the conversion.

In this example, you just converted retirement funds you previously received a tax deduction for into a tax free retirement stream paying NO taxes!  However, the long term impace is also strong and evaluated below.

To evaluate the impact of keeping the cash in a pre-tax traditional IRA versus a post-tax Roth IRA, we will compare the two scenarios over a period, assuming:

• Growth Rate: 7% annually
• Tax Rate Now and in Retirement: 30%
• Time Horizon: 20 years
  
  

1. Pre-Tax Traditional IRA:
   • Initial Amount: $120,000
   • Growth Calculation:
     • Future Value=120,000×3.8697≈464,364
   • After-Tax Value:
     • 464,364×(1−0.30)≈325,055
       
       
2. Roth IRA:
   • Initial Amount After Tax: $120,000 (converted with no tax due because of offset by nonpassive loss)
   • Growth Calculation:
     • Future Value =464,364
     • After-Tax Value: $464,364 (no tax due on qualified Roth withdrawals)
       
       
3. Comparison:
   • Traditional IRA (After Tax): $325,055
   • Roth IRA (After Tax): $464,364
     
     
4. The Roth IRA results in an additional value of:
   1. $139,309

By using a nonpassive loss from a cost segregation study to offset the taxable income of a Roth conversion, you can transfer funds to a Roth IRA without an immediate tax impact. Over time, as illustrated in this example, the Roth IRA can grow significantly more due to its tax-free nature compared to the pre-tax traditional IRA. 

We will caveat that these strategies are nuanced and we recommend discussing with your Tax Project Manager to determine if this is a viable strategy for you!