If you don’t know which kind of loss you have, the IRS will be happy to tell you. The problem is, you might not like what they have to say. Here’s a quick overview of the types of losses.
Many people get confused and think real estate is real estate. But the reality is that there are different types of losses, depending on the use of the property and the type of investor you are. So not all real estate losses are created equal.
(1) Loss while you’re holding property as an investment.
You don’t get any deduction AT ALL for any of the expenses associated with an investment. These expenses are all capitalized and added to the basis of the property. Do you have an investment property in the eyes of the IRS? You do if it’s not in service yet. Look for more audits in this area.
(2) Passive loss for real estate that is in service
Now let’s say you have a single family residence that is rented out. You’ve passed by the (1) issue above. But is it deductible on your return? Maybe not.
Let’s say you buy an interest in a Limited Partnership (LP). Or maybe you form a LP to hold your real estate. You know that the general partner has all the liability and so you use an LLC that you have to hold that 1% interest. The rest, the 99% is held as a limited partner. You can’t, by definition, participate in management except through your 1% owner. So, you have a passive loss that can only be used to offset passive income. That rule is true no matter how much money you make or if you’re a real estate professional.
(3) Material participation loss for real estate that is in service
Now let’s say you have that same single family residence and you’re holding it in a Limited Liability Company (LLC) or even, better, a Trust Sandwich™. So far so good.
Now do you pass the material participation test? That means you’re involved at least 500 hours per year per property.
Got that? If so, good! You can then take a loss of up to $25,000 on your return if you make less than $100,000 per year. If you make over $100,000, then you’re looking at a phase out of the deductible real estate losses. If you make over $150,000, you can’t get any loss deductibility at all.
There is an exception – if you’re a real estate professional. Being a real estate professional means that you must work more hours in real estate activities than you do any other activity and at least 750 hours per year. There is one more thing you have to do – and this is where a lot of people get messed up. You also have to materially participate in the property. In fact, you’ve got to spend 500 hours per property per year.
(4) Real Estate held as a business.
There is one more way you can have real estate investments. It’s real estate as a business. I’m sure this one is going to get misunderstood, so I’m going to tell you what it is NOT:
Real estate as a business does not mean you’re a real estate agent, at least as we’re defining it here. It does not mean you’re a property manager, architect, engineer, contractor or any other real estate activity based business.
It means the real estate itself is a business. And I have one more set of what it is not: It is not a real estate building that is used for commercial use. That would be real estate rental and in the previous categories of either passive or materially active.
Obviously, I’ve gone through these first 4 ways you can have a real estate loss really quickly. They are covered in depth in “Tax Implications of Real Estate Losses.”
I’ll go over the other 4 types of real estate losses tomorrow.