Passive Losses in Real Estate Syndications
When investing in a real estate syndication, it’s not uncommon to produce a net loss for tax purposes (thanks for depreciation and other expenses).
A common question that comes up from investors is: “I see this big negative number on my K-1. What exactly are these losses and how can I use them?”
In this article, we’ll answer this question and discuss what passive losses are, how passive losses are treated for limited partners, and how to use them.
[Disclaimer: We are not CPAs, so consult with your own tax professional regarding your unique tax situation.]
What are Passive Losses?
To help us understand passive losses, let’s first look at how the IRS defines passive activity.
IRS Section 469 defines passive activity as:
- Any trade or business in which the taxpayer does not materially participate, and
- Any rental activity of the taxpayer except as provided under Sec. 469(c)(7).
So basically, income or loss is considered passive when the taxpayer does not have a material role in the activity used to generate that income or loss.
In general, the IRS considers rental real estate activity to be passive. In a real estate syndication, the income generated is taxed as passive income. Passive losses result from depreciation, cost segregation and accelerated depreciation.
Passive Activity Loss Rules
Per IRS Regulations, a loss from a passive activity can only offset income from a passive activity.
Losses from passive activities cannot offset earned income.
There are two exceptions that allow taxpayers to use passive losses to offset earned (non-passive) income:
- Taxpayers with a Modified Adjusted Gross Income (MAGI) of less than $100,000 can deduct up to $25,000 of passive losses against other income. This $25,000 deduction is phased out $1 for every $2 that MAGI increases above $100,000. So once MAGI exceeds $150,000, the passive loss allowance is completely phased out.
- Qualifying as a Real Estate Professional.
Many physicians who invest in real estate syndications earn more than $150,000 and do not qualify as real estate professionals, so they cannot use passive losses to offset any of their earned income.
If their real estate investments produce passive losses in excess of any passive income, the result is a net passive loss. These losses become suspended passive losses.
Passive Loss Carryover
So what happens to these suspended passive losses?
Fortunately, they don’t just disappear. Instead they are carried forward indefinitely until you generate future passive income to deduct them against, or until the property gets liquidated.
For example, let’s say you’re invested in Syndication A that produces a net positive income of $5000 this year. This would be $5000 of passive income.
And you just invested in Syndication B. Thanks to cost segregation and bonus depreciation, Syndication B produces a loss of $50,000. This passive loss is passed onto you on form K-1.
You can use the losses from Syndication B to offset the income from Syndication A.
$50,000 (passive loss from Syndication B) – $5000 (passive income from Syndication A) = $45,000 passive loss
This $45K passive loss is suspended and carried forward indefinitely until you tap into the loss in the future.
Using Passive Losses
One way to use the suspended passive losses is to generate more passive income. Investments designed to produce passive income to soak up the passive losses are called passive income generators (PIGs). Examples include real estate and businesses where you don’t materially participate. As long as the passive income doesn’t exceed the passive losses, the income won’t be taxed because there’s no net income.
Conclusion
Passive losses is an important concept for real estate investors to understand. It’s important to recognize that passive losses can only be used to offset passive income, unless you qualify as a real estate professional. Any passive losses are carried indefinitely until you generate future passive income to deduct them against.
If you’re looking to get some passive losses or to generate additional passive income to offset suspended passive losses,, join the Clear Vision Investor Club to get notified of any upcoming real estate opportunities.
