Whenever I talk about the real estate professional status, I get a lot of questions. Without a doubt, it’s the most misunderstood tax break there is. And unfortunately, a lot of people did it wrong and so it’s also become an IRS audit target.
Here’s a question I received this past week:
I have rentals and income over $150,000 so I’m prevented from taking any real estate losses.
It was advised that I become a real estate professional so that I could group the property together and take advantage of carryforward writeoffs of a few hundred dollars.
What are the negatives?
I just want to first clarify the strategy with suspended losses. I think your carryforward losses are actually passive suspended losses. The real estate professional (REP) status will allow you to take current losses against your income. If there are enough passive losses to move you income below $100,000, you can use up $25K of your suspended losses. So you don’t immediately get to use those suspended losses if you become a REP. You whittle them down $25K at a time.
Although a lot of people like to talk about passive losses, my main question is why do you have losses. If you have losses because the income you make isn’t enough to cover the direct expenses, then you have an investment issue. I think that’s a negative. People get enamored of the tax breaks and forget about investing fundamentals.
Your loss should only come from depreciation. You can accelerate depreciation. You can catch it up. But once you’ve done these things, you will start to use up your depreciation. As the amount you can depreciation reduces, you’re back to being a taxable situation.
Can I put 3 or 4 in group? Keep one or two and still get 25G off, since overall, all values are up 3 to 4 times what I have paid for them. How if any other way to minimize taxes?
In order to be a real estate professional, there are three parts. You must pass all of the tests:
- You or your spouse must have at least 750 hours of real estate activities and more time in real estate activities than any other trade or business You must individually pass this test. You can’t combine hours.
- You and your spouse must have material participation. This means 500 hours or more of activity on the property, over 100 hours and more than any other person or more than anyone else combined. You can combine your hours for this. The IRS has taken the position if you have a property manager, you must pass the 500 hour test.
- Each property must individually pass the test.
When you talk about combining properties, I think you are talking about test #3. There is a way out of this. You can combine properties in a method called aggregation. This is an election you make on your tax return.
Put all in LLC? Individually?
It depends. If you’re going to be a REP, you need to make sure your LLC is manager-managed.
As far as how many in an LLC, that will depend on individual factors such as the state in which the properties are, the amount of equity and how risky the properties are.
I have given really short answers here to some strategies that need more comprehensive answers. At a minimum, I recommend you address the following with a CPA experienced in real estate:
- Real estate professional requirements,
- Strategy to use your suspended losses,
- Depreciation strategies to take just enough loss,
- Asset protection strategies with equity stripping and the right number of LLCs,
- LLCs set up and run correctly, and
- Estate planning.
If you’d like to schedule a consultation with me, please call Richard at 888-592-4769.