Investing in real estate property? Three loss limitations to keep in mind

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Real estate can be one of the best investments for your money, but only if it is done right. Real estate investing can result in possible passive income and long-term wealth and has the potential to increase in value over time; however, getting started in this type of investing often requires having either cash and/or financing readily available. Closing on real estate property will also incur closing costs, attorney fees, commissions and more. There will be maintenance costs, property taxes, mortgage interest and, potentially, management fees.

When it comes to investing in property, there are many questions to consider like: “Does investing in property mean I can write off expenses?” And while there is no question that real estate can be a good investment opportunity, it may or may not be the answer to creating current tax deductions.

When considering real estate investment, understanding loss limitations and their implications is key.

Losses are limited to your tax basis.

When investing in real estate it is important to understand tax basis. Basis is increased by contributing cash or property to your business, and by your share of income. Basis is decreased by distributions and your share of losses. Depending on your entity structure, debt assumed by an owner can potentially increase tax basis; however, the pay-down of debt decreases tax basis. As basis cannot go below zero, you cannot deduct losses more than your basis. Essentially you cannot take losses for more than you invested in the first place. If losses are in excess of your tax basis, these losses are carried forward to future years

Losses are only allowed to the extent a taxpayer is “at risk” with respect to that entity

Additional limits apply even if you have sufficient tax basis in an entity. In this format, risk is defined by whether you have either contributed money or property to the activity or taken on debt for which you are personally liable. At-risk basis is increased annually by any amount of income in excess of deductions, plus additional contributions, and is decreased annually by the amount by which deductions exceed income and distributions (Prop. Regs. Sec. 1.465-22(c)). For purposes of adjusting at-risk basis, income includes tax-exempt income, and deductions include nondeductible expenses. In a real estate context, an increase of qualified nonrecourse financing increases the taxpayer’s basis.

For example, if you are a limited partner in an LLC, you may be eligible to take advantage of “limited liability.” However, that could mean that you are not “at risk” with respect to that entity, thereby disallowing losses until future years when you have income, or you become “at risk.” You cannot take current tax losses in excess of your at-risk amount. Additionally, if at-risk basis decreases below zero, you may be required to recapture losses previously taken against that basis amount as income.

As a passive investor in real estate, rental losses are classified as “passive losses.”

Finally, even if you have sufficient tax basis and you are considered at risk, you may be subject to the passive loss rules. Passive losses are only to be used to offset other passive income. You cannot use passive losses to reduce ordinary taxable income, like wages. If you do not have other passive income, these losses can be carried forward to a year you do have passive income, or until you sell the property. Note that there is an exception to this rule: if your modified adjusted gross income is $100,000 or less, you may be able to deduct up to $25,000 of real estate losses annually.

Think before you invest

On the surface, investing in real estate may be a good way to reduce taxable income, but it is important to keep in mind these three loss limitations to make a sound and strong investment. If you have basis, you must be “at risk.” And finally, even with basis and amounts at-risk, if you are passive in an entity, it is possible those deductions will carry forward and not give you the current tax deductions you were expecting. Consulting with a CPA and walking through these three loss limitations, as well as other considerations such as related tax elections, tax credits and cost segregation studies, is one step in the right direction to smart real estate investing.

Jamie Crosley is a CPA, partner, The Bonadio Group. Jamie supports clients and small businesses tax planning and minimization, strategic planning, and accounting and tax preparation with special expertise in the real estate industry. Contact her at [email protected].

Disclaimer: The summary information presented in this article should not be considered legal advice or counsel and does not create an attorney-client relationship between the author and the reader.  If the reader of this has legal questions, it is recommended they consult with their attorney.