Real estate professionals have a distinct advantage when it comes to investing in real estate. Most people who invest in real estate have to follow what the Internal Revenue Service (IRS) calls Passive Activity Rules. These rules are found in Internal Revenue Service Publication 925.
When an individual invests in real estate, it is likely that, even if you have a positive net cash flow from the property, the early years may show a taxable loss due to depreciation, which is permitted to be taken on the property. Here’s a quick example assuming you acquired a 50-unit apartment for $7,500,000 ($1,125,000 was the land value and $6,375,000 was building value) in which you paid $1,875,000 in cash and borrowed $5,625,000 at 5% interest for 30 years and the units rented for $1,250 a month with a 5% vacancy and had operating expenses of $5,000 per year.
Gross Annual Revenue $750,000
Vacancy (5%) $ 37,500
Effective Gross Income $712,500
Operating Expenses $250,000
Net Operating Income $462,500
Annual Debt Service $362,355
Net Cash Flow $100,145
Deduct: Depreciation $231,818
Add: Principal Pay-down $ 82,989
Net Taxable Loss ($ 48,684)
In this example, the Net Cash Flow was $100,145, which is the money you put in your pocket, but the Net Taxable Loss which got reported to the IRS was a negative $48,685. This amount is called a Passive Loss and is due primarily to deducting the depreciation on the building over 27 ½ years.
The Principal Pay-down affects your Net Cash Flow but it cannot be counted when calculating Taxable Income or Loss. Therefore, the Principal Pay-down is added back to calculate Net Taxable Income or Loss because it is part of your mortgage payment but not considered an expense for tax purposes. Only the interest paid on the mortgage is a deductible expense for tax purposes.
In general, passive activity losses can be deducted only from passive activity income. Any excess loss can be carried forward to the following year or years until used or until deducted in the year the entire interest in the activity is disposed of in a fully taxable transaction.
If you or your spouse are not real estate professionals, but actively participated in a passive rental real estate activity, you can deduct up to $25,000 of the loss from the activity from non-passive income, but if your Modified Adjusted Gross Income exceeds $150,000, you generally cannot use the special allowance.
However, if you or your spouse qualified as a real estate professional, rental real estate activities in which you materially participated are not considered passive activities and you can write off the entire amount of Taxable Loss against your Adjusted Gross Income. In my next blog, I’ll tell you what it takes to qualify as a real estate professional.