Reducing W2 income tax by actively participating in real estate

[Masashi Borges-Silva]

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?

[David M.]

@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.