We recently discussed the benefits of passive income. The IRS defines passive activity as a business in which one does not “materially” participate in. However, a rental activity qualifies, no matter the level of the participation. One notable exception is if you are a real estate “professional,” which the IRS defines as someone spending more than half his/her time on real estate activity and greater than 750 hours in the business as a material participant. However, we are aiming this post at the non-professional real estate person.
Even if renting real estate is a sideline to your main career, it is incumbent upon you to understand the tax regulations that govern passive income and losses to make decisions that are more informed.
Making sense of taxes
IRS publication 925 lays out the taxation of the passive activity, including those generated from real estate activities. Starting with the punch line. Generally, you cannot have a passive activity loss in a particular year.
There is a nuance for real estate investors that may prove beneficial, however. You can “actively participate” in real estate if you and your spouse own at least 10% of the rental property and you make significant management decisions. The IRS gives examples that would qualify, including making decisions on new tenants and rental terms, as well as approving expenses. There is good news for you in this circumstance. You can use up to a $25,000 loss to offset that year’s other taxable income (single and married filing jointly filers).
However, there is a phase-out provision that is particularly relevant for New York City residents since it is a high-income area. The allowable $25,000 loss is chipped away if your modified adjusted gross income (MAGI) is more than $100,000, and there is no allowance if your MAGI is higher than $150,000.
A numerical example
It is useful to present a numerical example since this is a complex area. In this hypothetical example, you are single and own a condo unit in Manhattan. Just starting out in your career, you decide to rent the unit while earning wages from your regular job. Nevertheless, you make significant decisions, such as reviewing prospective tenant applications and approving the renter. Therefore, you are an active participant.
In the first year, your wages are $75,000, but there was a rental loss of $5,000, mainly due to the allowable depreciation expense. Since you are an active participant in the rental activity, you can use the $5,000 to offset your other income, which is $75,000 in this case.
Several years later, your wages grow to $175,000, and you have other income from dividends and interest. Any loss from the rental is disqualified, and you can only deduct the passive losses to the extent you have passive gains in that year. However, if you still have a loss, you can use this credit to offset future passive income.
Basic knowledge can improve your profitability, although business decisions should not be guided completely by tax considerations. There are NYS and NYC tax considerations, as well. Real estate can generate nice cash flow, but remember, it is the after-tax amount that matters.