A Conversation About Real Estate and Passive Losses

Today on the show we have Craig Cody, who is a Certified Tax Coach, a CPA, and a former New York City Police Officer, which is why he knows, unlike Andrew, that you aren’t allowed to kill somebody with your car. He also knows quite a bit about taxes. So today we’re going to be talking about taxation and how it relates to real estate investing, which I know is something that Andrew is probably chomping at the bit to learn more about since … What are you up to now, four properties? Three still?

Three. I live in one, and then three people live in my other ones.

Gotcha, okay. So you own four pieces of property.

Yes.

You’re just not really making money off of one of them. One of them’s your money pit?

Exactly, one is terribly expensive.

Craig, do you also do real estate investing, too?

I have at times. Currently, I’m doing college investing. As a matter of fact, my last one graduates this weekend.

Okay, nice, nice. Did you sell off your properties that you had then?

The last one I sold of about seven years ago. Unfortunately, the first one I sold off was recently sold at about a five time profit in Manhattan, so it hurts me to think about it.

Oh, wow.

 

I was going to say, Craig, to start, can you explain how rental income is taxed? There’s like all these things floating around. I want to hear it from somebody who actually does taxes.

Okay, so rental income after your expenses is taxed, in most cases, as ordinary passive income. If you’re an active real estate person, then it’s ordinary income.

So what’s the difference there? Passive versus active?

Passive really comes more into play when you have losses in your real estate, so passive losses, depending on how much money you make, can only be offset against passive income. If you make under, let’s just use $150,000, you get to take passive losses up to $25,000 a year. There’s like a sliding scale. The main thing is a lot of people have real estate, and they have these losses they’re generating, and they think they can offset all their income they’re earning. It turns out they’re making too money to be allowed to take the passive losses, so they have to figure out ways to generate passive income. That’s where tax planning comes in. Sometimes we figure out how to generate passive income.

Go on, tell me more.

Then you use that passive income to offset your passive losses that would otherwise-

I’m confused already.

Yes, yes, very confusing. The problem is a lot of people don’t realize, and there’s not enough communication between them and their professionals to realize that real estate’s a wonderful investment. A lot of times it throws off losses, but if you don’t really do some planning, those losses maybe deferred to some point when you have other passive income.

Okay, I feel like I now have like 10 question threads that I want to ask you, but to close out the first one, what is active income and what is passive income? Because if I don’t do anything to get my rental property, I get that that’s passive income, but I heard that rental income isn’t always passive income. I guess what you said, like a sliding scale of how much you earn …

More often it comes into play on the loss side, because if you have passive income in the losses you pay tax on it, whether it’s passive or non-passive income, but if it’s passive loss, you may not be able to deduct it. If you’re a real estate professional and you meet the criteria, which is basically if you have another job you have to actually be spending more than half of your working time doing your real estate, so you may not get the option of taking those losses immediately. They just sit there.

Let’s say I make $20,000 a year, because I really don’t work that hard, and I have rental properties that generate losses of $20,000 a year. You’re saying essentially at that point, because I’m at so low on the scale, I would pay zero dollars in taxes.

Correct.

Okay, not let’s say I work a little bit harder and I make $80,000 a year, well, I mean a lot harder, and I make $80,000 a year, and I have $20,000 in passive losses. How would you calculate that? Do I-

You would probably at that point still be allowed, probably be allowed, to take those passive losses.

Does that mean your net taxable income would be $60,000?

If we look at it just real generally, yes.

Let’s not get super specific, because I know there’s like an edge case for every state or whatever, and it’s ridiculous in a broad sense. However, if I worked really, really hard and never slept or talked to anybody and made $300,000 a year, and I had 20,000 in real estate losses, what you’re saying is I would be so far above in the scale that I would essentially be able to deduct nothing against my income.

Well, you’d have your income from your real estate and you’d deduct your expenses from there, but then if there was excess expenses, they would not move to your personal return or to page one of your return to where it would offset your other income.

What we’re saying is there’s like you can think of your real estate investing as a bucket, and if you have a net loss in that bucket, more losses than profits from your renters, then those are your passive losses, and we’re talking about how it affects the rest of your income, correct?

Correct, and that’s the reason why I’m a big proponent of planning. If you look and you do planning, you could figure out, do I fall into that? Am I not going to have these deductions? If I do, is there a way I could plan that we can create some passive income?

I want to go there, but one more question before we go there. Let’s say that I’m making 300,000 or whatever it is above the threshold, where I can’t deduct my losses against my income, do those losses just disappear and it’s just like a lost opportunity? Do I get to pass them on to my mom?

They sit there until you actually get to use them. It’s kind of like you wind up with your own personal balance sheet with these passive losses sitting there on your return.

So I could do it for years and accumulate literally hundreds of thousands of dollars in losses-

Correct, and then sell the property, and then those losses free up.

Oh, so if I have a really bad year, say 2013 I had no renters, I had to upkeep the property, and I lost $20,000. Then I sell that property in 2017, I could claim $20,000 of losses on it against the profit I make from the sale?

Correct.

Oh, wow, okay. Is there any sort of limitation of years, or can you just, like if I had losses from 1960 or something, can I get-

They just say with that entity-

Okay, interesting.

… that piece of real estate, so it’s really important. This is not an uncommon thing we see, where people go from professional A to professional B, and professional B doesn’t really take those passive losses that were sitting on their tax return and move them onto their new program. Preparer A has his own software, and Preparer B has his own software, so we see that.

So people lose their losses due to like paperwork stupidity.

Yes, correct.

Oh, shit.

That could be an expensive mistake.

Yes, it can, and I’ve seen some very expensive mistakes.

Kind of a tangent here, do these passive losses only apply to real estate or do they apply to something else?

What we’re talking about have to do with real estate, but there are other ways to have passive activities that can generate losses.

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