There are three big reasons why people invest in real estate: cash flow, capital appreciation, and the tax breaks. Today we’re talking about how real estate can create losses that put money in your pocket.
The best of all worlds is when real estate creates a cash flow–and you don’t have to pay any tax on the money. Not only that, there is a paper loss created that you can use to offset other income. Oh, and by the way, the asset that creates all these things is going up in value.
That’s why we love real estate. But it’s not always that easy or straightforward. For example, the losses that are created are becoming more difficult to write-off against other income.
There are three types of real estate loss you may have from real estate that you are holding:
- Real estate loss where the real estate is actually a business
- Real estate loss where the real estate is an investment
- Real estate loss where the real estate creates a passive loss
#1: Real estate loss where the real estate is actually a business
If you rent out your real estate for short periods of time (less than a week) and provide some other kind of services (like housekeeping), you have a real estate business. That means your income is considered ordinary income and your loss is an ordinary loss.
That is a big deal. The real estate loss can be used to offset any kind of income without any kind of limitations.
If you are a real estate dealer, as defined by the IRS, you also have a business. That can mean some other tax issues, but for purposes of real estate losses, it’s a good thing. The losses can directly offset your other income.
TIP: If you have rental property that currently is running a loss, talk to an experienced tax professional to determine whether any of it could be considered a real estate business. If it is, you’ve got a deduction!
#2: Real estate loss where the real estate is an investment
By this time, your eyes may be crossing a little. Of course your real estate is a business. Of course your real estate is an investment. But in this case, logic goes out the window. We are using IRS definitions.
A real estate investment is one that is not yet put in service. For example, let’s say you buy a bare piece of property. That is an investment unless you are renting it out to someone.
The expenses that go along with an investment need to be capitalized. That means the costs are coded as an asset and later down the road are either expensed, depreciated, or amortized. But meanwhile, there is no deduction.
TIP: If you have real estate that is an investment, you may want to put it in service first to get to take advantage of the loss.
#3: Real estate loss where the real estate creates a passive loss
If you have a rental property that is put in service and is not a business, then you have a passive investment.
If there is a loss, you can deduct up to $25,000 of the loss against other income as long as you have active participation in the property and your income is less than $100,000.
If your income is over $150,000, you can’t take any of the loss against other income.
Between $100,000 and $150,000, the amount of the loss phases out.
There is an exception: the Real Estate Professional Deduction, which I will write about in my next article, “Safely Taking the Real Estate Professional Deduction.”