Reducing W2 income tax by actively participating in real estate

Tax, SDIRAs & Cost Segregation
4yFollow

Reducing W2 income tax by actively participating in real estate

Masashi Borges-Silva
Investor · Manhattan, NY · Member since 2018 · 103 posts · 70 votes

Background

I am not a Professional Real Estate (yet) as I am working as a full-time engineer, and I don’t meet 750 hours of services during the tax year in real property trades or businesses in which I participated. I don’t own a property (yet), but I am trying to figure out ways to reduce W2 income taxes. I am also not a professional CPA or in a position to provide such advises, and below are what I read and how I understand it. Please seek professional services appropriately.

Question

What are examples of “loss from rental real estate activities” mentioned in Special $25,000 allowance found in Publication 925 (2021), Passive Activity and At-Risk Rules?

The definition of the Special $25,000 allowance I found is here, and an example used in the document is as follows:

Example. Kate, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, a $26,000 loss from rental real estate activities in which she actively participated, and isn’t subject to the modified adjusted gross income phaseout rule. She can use $15,000 of her $26,000 loss to offset her $15,000 passive income from the partnership. She actively participated in her rental real estate activities, so she can use the remaining $11,000 rental real estate loss to offset $11,000 of her nonpassive income (wages).

Ok, this is where I might need more help for me to understand the allowance.

Can rental property depreciation be applied as loss from rental real estate activities?

In this example above, I am assuming that $11,000 will be deducted from $70,000. The adjusted gross income would be $59,000, and the tax saving would be $2420 (assuming there are no other deductions applied).

Let me describe how I calculated the tax saving. By using the 2021 bracket and both gross incomes ($70k and $59k) would fall under the same 12% bracket (between $19,900 and $81050), the total tax I calculated for each is $8602 for $59k income and $11,022 for $70k income, and finally, the difference of the two scenarios is $2420.

One of the many “losses from rental real estate activity” I can think of is the depreciation of the property. For example, if I bought a property at $100,000, can I claim that $3,636 (depreciation over 27.5 years is calculated as $100,000 divided by 27.5 years = $3,636/year) is considered as a part of rental real estate loss? Similarly, if I bought a property at $700,000, and the depreciation over 27.5 years is calculated to be $25,455 ($700,000/27.5 years = $25,455/year), then this depreciation would reach the maximum allowance that any other “loss from rental estate activities” are no longer applicable.

Examples of other posts related to my questions

Is the $25,000 special allowance only for Married individuals? In this thread, the author is asking if the special allowance for single individuals would be $12,500

*Interpretation of 8582 Special Allowance for Rental RE Activities:* In this thread, the author is asking about the difference between “nonpassive” and active (W2) income and special cases in which up to $25,000 of passive losses can be used to deduct from a W2 income.

*$25,000 Offset Question???* In this thread, the author is asking about is $25,000 is offset from your earned income.

After thought

I am in search of a CPA/financial advisor to discuss tax planning and tax saving strategies. Do you have any recommendations?

2Reply
178 views

Most Popular Reply

David M.
Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
4y

@Masashi Borges-Silva

Let me try to sum up this way....

You have income / expenses for your rental activity.  They are either a mathematical (positive) profit or a (positive) loss --- as opposed to a loss being represented by a negative number....  So, just take your rental income, less depreciation, less all your other allocable expenses.  Then, either way take the absolute value and annotate whether its profit or loss.  Profit isn't discussed much in the IRS docs because its pretty easy, it just goes onto your 1040 and you pay tax...  Losses on the other hand get more complicated (and the IRS just refers to it as a positive number).

I guess for starters, you basically can't take losses onto your 1040, unless you meet the variety of exceptions.  The biggest one is passing the IRS' definition of a Real Estate Professional Status which is the 750 or 500 hours of material participation and more than half your time is from real estate activities.  As an engineer and hopefully with a w2 job, its should be nearly impossible to pass.  With your day job that is about 2000 hours a year, that means you need to spend at least 2001 hours on real estate.  So, some how you are working 4001 hours per year, at least.

Then, comes a $25k deduction allowance.  If you participate some 500 or 750 hours (I dont' remember anymore), you can deduct up to $25k if your modified adjusted gross income (MAGI) is less than $100k.  It phases out to zero at $150k --- so for every $2 of "non-rental income" you can take $1 less of passive losses.  The MAGI in this case is basically what your agi looks like if you didn't consider any rental actiivities.  This irrevelant if you are single or married as I recall.

Passive Activity Losses (PAL) is basically the "bucket" of losses that you "generate" (assuming you have losses) and are carryied over year after year (assuming you aren't able to take them onto you 1040 or offset via positive profit from your rental activities).  

N.B.  to determine depreciation, you can only depreciate the improvement portion of your property.  Land can't be depreciated.  So, you usually determine the ratio of improvement to land via the assessment values.  Use that ratio to determine what proportion of your cost basis is improvement, and then depreciation that (the 27.5 years).  

All in all, you don't invest in real estate to decrease your w2 taxable income.  Its an investment to accrue wealth.  The "magical" deductions that everybody claims is to offset your the rental income so that you don't pay tax, or less tax, on the rental income.

3Reply
See this reply in the discussion

11 Replies

Jump to latestLatest
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    4y

    @Masashi Borges-Silva

    Let me try to sum up this way....

    You have income / expenses for your rental activity.  They are either a mathematical (positive) profit or a (positive) loss --- as opposed to a loss being represented by a negative number....  So, just take your rental income, less depreciation, less all your other allocable expenses.  Then, either way take the absolute value and annotate whether its profit or loss.  Profit isn't discussed much in the IRS docs because its pretty easy, it just goes onto your 1040 and you pay tax...  Losses on the other hand get more complicated (and the IRS just refers to it as a positive number).

    I guess for starters, you basically can't take losses onto your 1040, unless you meet the variety of exceptions.  The biggest one is passing the IRS' definition of a Real Estate Professional Status which is the 750 or 500 hours of material participation and more than half your time is from real estate activities.  As an engineer and hopefully with a w2 job, its should be nearly impossible to pass.  With your day job that is about 2000 hours a year, that means you need to spend at least 2001 hours on real estate.  So, some how you are working 4001 hours per year, at least.

    Then, comes a $25k deduction allowance.  If you participate some 500 or 750 hours (I dont' remember anymore), you can deduct up to $25k if your modified adjusted gross income (MAGI) is less than $100k.  It phases out to zero at $150k --- so for every $2 of "non-rental income" you can take $1 less of passive losses.  The MAGI in this case is basically what your agi looks like if you didn't consider any rental actiivities.  This irrevelant if you are single or married as I recall.

    Passive Activity Losses (PAL) is basically the "bucket" of losses that you "generate" (assuming you have losses) and are carryied over year after year (assuming you aren't able to take them onto you 1040 or offset via positive profit from your rental activities).  

    N.B.  to determine depreciation, you can only depreciate the improvement portion of your property.  Land can't be depreciated.  So, you usually determine the ratio of improvement to land via the assessment values.  Use that ratio to determine what proportion of your cost basis is improvement, and then depreciation that (the 27.5 years).  

    All in all, you don't invest in real estate to decrease your w2 taxable income.  Its an investment to accrue wealth.  The "magical" deductions that everybody claims is to offset your the rental income so that you don't pay tax, or less tax, on the rental income.

    3Reply
  • Masashi Borges-Silva
    OP
    Investor · Manhattan, NY · Member since 2018 · 103 posts · 70 votes
    4y

    @David M.

    First of all, thank you for your response, and I really appreciate your taking the time to write me a reply. That means a lot to me.

    Having said that, I have follow-up questions.

    What do you suggest that seems to work for other real estate investors who started out in a similar situation as mine?

    I don’t qualify as a real estate professional as I don’t work 750 hrs in real estate, and I don’t plan to work 2001 hrs in real estate in parallel with my w2 job as an engineer either.

    I also don’t have any rental income simply because I don’t own any rental property, and I am exploring the idea of purchasing a turn-key property from a company similar to RentToRetirement.com. In the process, I want to use my 401k and savings for down payments for one property (ideally a small multifamily unit). for this to work for me, I need to be actively participating.

    For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

    This means that I have to work with property management teams to hand over some of the “decisions” for my rental property.

    I am working full-time with a W2 income, and I want to know how I can maximize tax incentives while I am transitioning to being a real estate professional which is defined as the following:

    Qualifications.

    You qualified as a real estate professional for the year if you met both of the following requirements.

    • More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
    • You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

    Real property trades or businesses.

    A real property trade or business is a trade or business that does any of the following with real property.

    • Develops or redevelops it.
    • Constructs or reconstructs it.
    • Acquires it.
    • Converts it.
    • Rents or leases it.
    • Operates or manages it.
    • Brokers it.

    Basically, I need a CPA who can work with me and understand my situation fully. My goal is to plan and take action to maximize the benefit of tax incentives in such a way that I can reinvest with tax-saving money and ultimately build my wealth.

    I have questions such as:

    1. What type of retirement account would be best for my situation? I am planning to borrow $50k from my 401k into my second non-personal checking account specifically made for real estate investments. Also, how can I use Roth 401k towards the first rental property without tax burden or penalties?
    2. How can “start-up costs” help me save in taxes? Can I write off the fee paid for CPA? some “investor-friendly CPAs” charge between $2000 to $3000 annually, and I can’t justify the cost as I don’t have any rental income “yet.”
    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    4y

    @Masashi Borges-Silva

    No, you don't have to work with a property manager... I self-manage and thus I am making my own decisions of exactly what you cited..  I approve the new tenants, decide on the rental terms (I have my own lease and approve any changes), approve expenditures (I'm the one who orders them), etc...

    Honestly, your situation isn't that unique at all.  Its very common for high W2 earners to invest in real estate.  You just don't have them commonly on boards such as these because they don't have as many issues normally since they have the income and resources to invest.

    In general, whatever costs you have will be deductible.  As mentioned, you passive losses will be carried over year over year until offset by gains, similar to stocks.  But, as for startup costs before you start, I know for a "regular" business they are generally deductible (their is a section in the IRS pubs that discusses it at length but it doesn't really apply to me so I don't remember).  If you are asking if you can apply if you pay for a CPA now and finally invest in a few years, I really don't know.  Like I said, there isn't anything special about your situation.  If anything, it seems pretty plain to me.  I work with a larger accounting firm so they would be no problem handling your returns, as I would think a smaller accounting firm.  

    Borrrowing from you 401k account doesn't provide tax advantages. Looks up using a self-directed IRA, or sometimes called checkbook IRA. Its a special type of account where you do have "checkbook" access to the IRA. I don't do it. But, basically the IRA takes owneership of a LLC from which you have managing authority to invest, in this case real estate. So, you'd need enough funds to purchase the real property and run it from inside the LLC/ IRA. The gains are all tax free in accordance with your IRA terms (.e. regular IRA vs Roth IRA). I honestly have no idea what happens to any losses as I haven't seen it talked about and as far as I'm aware you can't tax lost harvest within a IRA account.

    So, are you saying that you in the near term will stop your W2 income or significantly reduce your hours and be working full time in real estate?  Without the W2 income, whats the point of generating losses to be used via the Real Estate Professional Status?  Furthermore, like I posted earlier, if you have losses to show it could mean you aren't making any money (granted, non-cash deductions such as depreciation could temporarily tip the scales).

    0Reply
  • Dan Schwartz
    Real Estate Investor · Tempe, AZ · Member since 2012 · 874 posts · 648 votes
    4y

    @Masashi Borges-Silva you’re reading up on a lot of IRS publications, which is great.  But you’re also chasing a Holy Grail that many others come here seeking.  

    The best, and sometime only, way to reduce the tax burden of your W-2 job is to reduce your W-2 earnings.  

    Since we all generally like having more money rather than less money, the best way to reduce your W-2 earnings is to use your (presumably) high earnings to generate replacement, tax-advantaged income.  

    This could be buying stocks that throw off big qualified dividends. 

    This could be forming a business in your profession to enable deduction of ordinary and necessary business expenses. But you’ll also get an immediate 7.65% tax increase due to self-employment taxes, and the size of the deductions aren’t always what people purport them to be (the ability to get a solo 401k is pretty awesome, though). 

    This could be buying income-producing real estate, which often provides a cash profit while at the same time creating a tax loss that defers the payment of tax well into the future.  

    I suggest focusing your energy on converting the income, while you have it, into tax-advantaged income streams rather than try to contort yourself into a situation (often by taking large, actual cash losses) where you can offset some of your W-2 income to avoid taxes.  

    0Reply
  • JD MartinBusiness Member
    Moderator
    Rock Star Extraordinaire · Northeast, TN · Member since 2015 · 10k+ posts · 17k+ votes
    4y

    The easiest way to make this work if you have a regular W2 that you don't want to quit is to have a spouse that doesn't work and file a joint return. S/he would still have to pass the material participation qualifiers but that's a whole lot simpler if your only "job" is working on and managing your rental properties. If your spouse was a low wage earner, it's possible that savings from not working plus tax savings can be greater than the wages earned. 

    You personally cannot pass the litmus test with a regular job unless that job is materially related to real estate. You won't make that work as an engineer unless you could demonstrate most of your work was solely dedicated to real estate trades, which will also be difficult if you don't work for yourself. 

    Podcast Guest on Show #243
    Skyline Properties
    View Page
    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    4y

    @Masashi Borges-Silva Listen to @Dan Schwartz and @JD Martin. I've tried telling you mostly similar before but I think it got lost in the weeds. Additional tax advantage accounts might be 529 plans for education, IRA, etc. Having a non-working spouse is another great idea. Usually work much better if she is the one "running" the rentals if the IRS checks more deeply.

    You aren't understanding that the tax advantages that people speak of as it relates to passive real estate investing is for offsetting the rental income, not for offsetting YOUR own income.  Its great idea to want to stop working an active job, who doesn't, but it takes a lot of investment/wealth to get there.  Good luck.

    1Reply
  • Drew SygitBusiness Member
    Property Manager · Royal Oak, MI · Member since 2012 · 13k+ posts · 9k+ votes
    4y

    @Masashi Borges-Silva as others have stated, you're going to fail at trying to find a legal way around the IRS requirements. Of course, you could just commit fraud and take your chances.

    Look to acquire a 2-4 unit property with an FHA low-down payment mortgage.

    Getting it under market value would be a bonus.

    So, would using an FHA 203k renovation loan, which would allow me to buy something unqualified for a standard mortgage, which would weed out a lot of competition and push the price lower.

    Hopefully, you can increase the value of the property in 1-2 years and be able to refi out of the FHA mortgage. You'd also learn a lot about maintenance and managing tenants.

    Then, with your hands-on experience, you could decide if you wanted to repeat the process or target 5+ units - which your experience would help with lenders.

    Good luck with whatever you decide to do!

    [email protected]248-209-6824
    Logical Property Management4.9469 Reviews
    WebsiteView Page
    0Reply
  • Julio GonzalezPro Member
    Specialist · West Palm Beach, FL · Member since 2008 · 4k+ posts · 1k+ votes
    4y

    @Masashi Borges-Silva As someone already mentioned, the easiest way to turn your real estate portfolio active would be to have you spouse (your post didn't state whether you were married or not) qualify for real estate professional and file a joint tax return. 


    To answer your questions "Is the $25,000 special allowance only for Married individuals? In this thread, the author is asking if the special allowance for single individuals would be $12,500" No, this just means that the maximum allowance you get is $25,000 regardless of if you are single or married. It's basically just saying that you can't double that allowance if you're married.

    For depreciation, it doesn't directly count toward the loss. Your loss is rental income less expenses (including depreciation). You have the straight-line depreciation part correct, but you need to subtract out the land value before dividing it by its useful life, so your depreciation expense would be less than what you calculated above. There's also the option of cost segregation if you're wanting to generate more losses in the early years (also depends on how much income you're expecting from the property.) Any unused losses roll forward to future years.

    Have you ran the numbers on the property that you are looking at to determine if it cash flows? This can be difficult sometimes with turn key properties. There's a big difference between having losses generated from non-cash activity (such as depreciation) and the property having negative cash flow and draining your resources.

    If you need a CPA recommendation, I've worked with many CPAs over the years and would be more than happy to provide some recommendations.

    561-253-6640
    0Reply
  • Masashi Borges-Silva
    OP
    Investor · Manhattan, NY · Member since 2018 · 103 posts · 70 votes
    4y

    Thank you all for your input.

    After digging more into this topic, I learned that short-term rental income can be used to offset my W2 income, so I am starting to investigate the area to invest in the upper State of New York.

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    4y

    @Masashi Borges-Silva

    That is true.  If you run a short term rental more like a hotel with all those extra services the income is categorized as active, instead of passive.  However, you do realize that "decrease your W2 income" you still effectively have to be claiming losses from the short term activity, right?

    Lets face it, if you are paying taxes that means you are making money.  Tax efficiency is the key...

    0Reply
  • Dmitriy Fomichenko
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
    4y

    You are on the right path, keep searching and keep learning. Over the last few years I was able to minimize my taxes almost to zero while my income keeps growing. The beauty of investing in real estate! 

    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free