Passive activity loss rules are complicated. These rules prevent you from using your rental tax losses to offset your active income. A basic understanding of the rules will save you thousands of dollars in tax over your investing career.
And knowing how to review your tax return to make sure these rules have been applied successfully is an investing superpower.
For example, if you opened your tax return, can you get the amount of suspended passive losses carried forward to the next year? And can you easily determine whether the loss from one rental offsets your income from another passive activity?
It is important to know how much suspended passive loss you are carrying forward for making decisions regarding rental buying and selling.
Unfortunately, very few investors know how to monitor this information. In this article, I’ll walk you through the idle activity rules and how to track down suspended tax losses from your rental.
Tax Returns Are Overly Complicated, and Investors Don’t Know What to Review
When You Get Your Tax Return Back From Your CPA, Do You Know How To Review It?
Probably not, because:
- You haven’t had any formal tax training.
- The tax code is incredibly complex, and you don’t know all the rules.
- You may not know where to start or which forms are important to check.
- Asking your CPA questions is intimidating (no one wants to appear uneducated).
In the following steps, I’ll show you how to review a specific form: Form 8582.
Form 8582 is probably the most important tax form in your entire tax return. It shows the netting process of passive income and losses (i.e., rental losses) and keeps track of your total suspended passive losses.
Step 1: Understand the Idle Activity Rules
Before I tell you about Form 8582, I want to give you a basic understanding of the passive activity loss rules that went into effect in 1986.
These rules effectively generated two types of income: passive and non-passive.
And here’s the problem: Losses from passive activities may not offset income from passive activities, but losses from passive activities may not offset income from passive activities. non passive activities.
A passive activity is any rental activity unless you qualify as a real estate professional and any trade or business in which you do not materially participate. Your rental loss (a passive activity) cannot offset income from your W-2 job or business (a non-passive activity) in which you actively participate.
If you meet one of the exceptions to the passive activity loss rules, you can use the rental loss to offset your non-passive income. This situation typically occurs when the loophole of a real estate professional position or short-term rental comes into play.
If your passive rental losses cannot be used, meaning you do not qualify for the exception to the passive activity loss rules and your passive losses exceed your passive income, the excess losses are suspended and future carried forward over the years.
Tracking suspended passive losses, and going through this netting exercise, is where Form 8582 comes in handy.
Step 2: Review the Netting Process
The net of passive activities confuses both investors and accountants.
To give you some clarity, here are some examples of how passive activities stack up against each other:
- The loss from rental A can offset the income from rental B.
- A loss from a limited partnership (LP) investment in a syndicate can be offset by income from rental A.
- The loss from the LP investment in a syndicate can be offset by the gain on the sale from rental A.
- Income from investment in a business (assuming it is structured as a passthrough and you are not materially participating in it) can be set off against rental loss.
- The loss on rent can offset the income from passive investment in the surgical center.
This trap is powerful.
Let’s look at some examples of Form 8582:
Example 1: How passive rental loss offsets passive rental income
In Part 1 of Form 8582, you’ll find that all passive income and losses are reported on line 3 and are netted against each other. As you can see in the image below, this investor’s rental income and loss is being reported on line 1a and. 1b. The net is reported on line 1D and moved to line 3.
Example 2: How Gain on Sale of a Passive Rental Activity Allows You to Use Passive Losses
Sometimes we hear feedback from landlords that their accountants will not allow passive losses to offset gains on the sale of rental properties. In that case, I point you to Temp. Reg. Sec. 1.469-2t, where you’ll find that a gain from the sale of a passive activity (i.e., rental property) is included in “passive activity gross income,” thus allowing the passive loss to be set off against it.
The image below assumes that we sold the rental at a gain of $50,000, as reported on Form 4797 and carried over to Form 8582, and had a passive loss from other rental activities of $25,000.
Example 3: How passive LP losses offset passive rental income
The image below illustrates the effect of investing in a real estate partnership and receiving a tax loss reported on the partnership’s Form K-1. LP loss is reported on line 2b and carried to 2d. But this investor’s passive rental income is also reported on 1A and carried over to 1D. And then on line 3 the 1D and 2D net outs.
Example 4: How passive rental losses offset passive business income
The image below shows how you can use passive rental losses to offset passive business income. The rental loss is reported on line 1b and carried over to line 1d. Passive business income (assuming you don’t meet one of the seven material participation tests) is reported on Line 2A and carried over to Line 2D. And then on line 3 the 1D and 2D net outs.
Step 3: Review your Suspended Losses
The suspended loss is the last important part of Form 8582 that you need to pay attention to.
On page 2 of Form 8582, Part VIII, you’ll see a list of your inactive activities (or refer to a statement if you have too many activities to fit on the lines). In column B, you will see the unadjusted loss per idle activity. The total amount is the suspended passive loss that you carry forward each year.
You’ll see this number on page 1 of the next year’s Form 8582, which is being reported on lines 1c and 2c in Part 1. And that means they can be used against future passive income from rental and business activities.
Tracking this number is extremely important for three main reasons:
- This can help you decide whether to use a cost segregation study.
- This can help you decide about 1031 exchanges (if you have large suspended passive losses, you may opt to sell your rental outright instead of executing a 1031 exchange).
- This will help you hold your accountant accountable for quality work (sometimes, in years you change accountants, the new accountant forgets to carry forward suspended losses).
Summary
The passive activity loss rules enacted in 1986 created passive and non-passive income.
Passive losses can offset passive income. Understanding this netting effect can help you plan your activity participation year after year.
But, unless you qualify for an exception to the passive activity loss rules or do not materially participate in a trade or business activity, passive losses cannot offset non-passive income.
Finally, tracking your suspended passive losses annually will help you make buying and selling decisions and hold your accountant accountable for high-quality tax returns.
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Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.
