Passive loss carryover, should it be minimized?

Question

Hello,

We are learning more of the in's and out's of depreciation, trying to decide how to handle depreciation on some properties.

Basically:
* Our AGI is past the point where we can deduct any passive loss carryover against regular income.  
* We expect there to be passive losses (at least initially) due to depreciation expenses.

While you are renting out a property it is clear that having enough depreciation expense is good, so you are not paying tax on the cash flow (and the future 25% depreciation recapture is a lower rate than the income tax rate, i.e. spending 25% in the future to save 30+% now).  
But, if/when we sell a property, it seems like any "passive loss carryover" gets applied to current expenses, then to capital gains on the sale (taxed at 15% + 3.8%), then to any regular income you have.  So if there are high (hopefully) capital gains it seems like you are spending 25% (depreciation recapture) to save ~19% (capital gains).

So, in general, is it a good idea to try to minimize passive loss carryovers?  
Or do people go for a 1031 if there is a large capital gain?  
(i.e. it looks like you have the option to elect a 40 year depreciation instead of 27.5 years but only can choose that in the first year)

Thanks!
Eric

Bill Walston · Answer

Eric Lee, I think the answer to that question would depend on how you plan to minimize the loss.  You mention depreciation on properties.  If your plan is to minimize the loss by NOT taking depreciation on the properties, that won't work.  The IRS reg refers to "depreciation allowed or allowable."  This means that the Service will determine the tax consequences of the transaction as though you had taken the depreciation expense, even if you do not.

If you mean to minimize the passive losses by decreasing actual operating expenses, then I would be all for that :)

I still find it amusing to hear folks talk about investing in real estate for the tax losses.  That should be a side benefit, not the sole reason for the investment.  Just sayin'

Steven Hamilton II · Answer

Eric Lee,

Bill Walston knows it backwords and forwards.  He is correct.  There is no option.

You do not get to select how long it is depreciated over.  For residential rental property it IS 27.5 years. Commercial is 39 years.  Foreign rental property is 40 years.

-Steven

Bill Exeter · Answer

@eric_lee.  Yes, suspended passive activity losses are deferred (rolled over) if the investor structures a 1031 Exchange transaction.

Dave Toelkes · Answer

@Gary Gibson

I am also interested in Steven's response, but while we are waiting to hear let's consider the impact of your strategy.

If you elect to finance the property, you get a mortgage interest deduction of $25K per year that is effectively paid by your tenant(s) from collected rent.  This mortgage interest offsets your taxable rental income which also reduces your tax liability.  Since you are paying the mortgage interest from your tenant's rent, you get the tax benefit of the mortgage interest deduction without paying any money out of your own pocket.  Your tenant is really buying the property for you.

Add the depreciation deduction to the allowable expenses, and (from your numbers) you have a net rental loss of $22K per year.  If your income is too high to take the net rental loss as a passive loss allowance, you accrue the loss and carry it forward each year until you can use it.  If you sell the property in ten years, and you have $220,000 in accrued rental tax losses, you get to take the entire loss against all your taxable income without regard to the net passive loss allowance caps.  In the year of sale, this effectively reduces your taxable income from all sources by $220,000.  If your income is high enough to put you in the 30% (or higher) tax bracket, you do come out ahead after paying the 25% tax on unrecaptured depreciation.

The sum total of the tax benefits is that you may actually reduce your tax bill to the IRS, and, your tenants are buying your property for you without taking money out of your pocket.  In this situation, why would you pay cash for the property?  Seems like you come out ahead by financing and using your available cash to purchase more properties.

If you are not yet convinced to finance your property purchase, let's consider the return on your invested capital.  With financing, you have a net positive cash flow of $5K per year (depreciation does not take any money out of your pocket, and thus, does not reduce your cash flow).  Assuming you are purchasing a $750K property and putting 20% down, your annual cash flow gives you a 3.33% return on invested capital.  Pay cash to purchase the property outright, you increase your annual cash flow to $30K per year but only increase your return on invested capital to 4%.  By paying all cash, you will tie up an additional $600K in equity that increases your yield on invested capital  by only 0.67%.  Given your ten year timeline, you would do much better on a net cash flow basis by financing the property and using the extra $600K to purchase 10 year Treasury bonds yielding around 2.8%.  Consider also that the yield on your Treasuries is tax free on your federal income tax return..

Just how I see it.

Cindi Anderson · Answer

I know this is an old post, but wondered if this also applies to non-passive losses?  One of my properties is a vacation rental which is also classified as a second home since I live there part of the year.  In this cases the losses are not passive.  They get carried forward until the specific property has a profit to use them against.  Will I be able to use these to offset capital gains like the above examples?

Also, you calculate this on worksheet 5-1 schedule E, but I haven't found any form to record the carryforwards.  Where do these get recorded?

Thanks!

Chris Haydis · Answer

@Gary Gibson

Another important thing to remember about passive losses is that it is allowed to be carried forward but it is also first carried back two years by default, so you have to go back in the last two years and see if you can write off the passive losses against any passive gains. That is the default tax treatment for passive losses, but you can elect to forego the carryback period and only carry it forward if you elect to do so in the first year. Passive losses can be carried forward for up to 20 years so if you waited 30 years to sell the house you would only benefit from the last 20 years of passive losses.

I hope this helps at all, the tax code is not easy by any means. Also @Bill Exeter I hope all of this information is correct, I'm not a tax professional (yet, I'm in my third year of an Accounting Degree) but this is what I understand of passive losses that hasn't been mentioned yet.

Good luck!

Chris Haydis

Eric Lee · Answer

Gary, Steven,

I think this is a great discussion.  I found this very confusing also.  When I was digging into this earlier, though, my understanding ended up being that "excess passive losses" are applied against income in this order:

* Income from the passive rental activity during the year (which would be taxed at ordinary income rates).

* Gain from the sale (offsetting fed tax of 18.8% (if have 15% long term cap gain rate (for married joint income of 72.5k to 450k) + 3.8% medicare on unearned income)).

* Then against income from all other passive activities.

* Finally against all other income (i.e. active income from a salary).

This was from "Every Landlord's Tax Deduction Guide", in the "Profits from Sale of Property" section.  If there was something I missed, though, I would love to hear about it.

So it seemed to me that you DID end up paying 25% in depreciation recapture, to "save" 18.8% of capital gains (if you have a lot of capital gain, which you hopefully would).  i.e. a "net federal tax" of 6.2% on the suspended passive losses in the year of sale.

For California state tax, I know the calculation is different, and I think depreciation recapture does not apply, but would have to check that again.

It seemed that there were a couple of options to reduce this,

* One was to elect the 40 year depreciation in the first year, to slow the rate passive losses accumulate.

* Another thought is that if rents rise over time (hopefully true) then the passive losses would be consumed partially that way also (ideal case).

* I think a 1031 exchange causes the "suspended passive losses" to roll forward into the new property, so the depreciation recapture does not occur, but am not certain.

In the end we personally still ended up wanting to mortgage our new purchases, under the idea that we could obtain several properties with the same amount of cash, and would have capital gains on several properties as well.  Plus we don't think rates will ever be as low in the foreseeable future, so if we want to take out cash from the property now is the time.

Best Regards,

Eric

Gary Gibson · Answer

Thanks Steven - that is VERY helpful - (and no, if I did a mortgage, it would not be interest only).  I just wanted to make sure I could carry forward the loss and eventually apply it to ordinary income - otherwise, it seems to make the mortgage quite a bit less attractive.

Steven Hamilton II · Answer

The choice to finance or not is yours. I think you could make a substantial return with your capital. I hope the loan wouldn't be interest only.

Steven Hamilton II · Answer

@Gary Gibson ,

I also need to now your tax bracket or what you would expect that to be.

Your depreciation would be assuming land is 50k 750k-50k = 700k / 27.5 = 25,455 of depreciation.

If your rent is 65k per year

65k Rent

-35k Expenses

-25.5k depreciation

-25k interest

-20.5k Loss.

If your income is over 150k you will not be able to deduct 20.5k of loss. That gets carried over year after year until it is used or the property is sold.

If you sold January 1 of year 11 and the value is $1 million.

Assuming the same thing every year:

Your passive loss carryover over 10 years would be 205k.

Your adjusted building basis would be 445k.

Your accumulated depreciation would be 255k

Your Land Basis would be 50k.

You will then recognize the gain or loss on the property separately.  Yes you will recapture the depreciation of 255k at UP TO 25%.

Now in the year of sale you will deduct 205k in losses on your tax return against your ordinary income or capital gain as well.

You will sell the land for 100k.

You will sell the building for 900k.

You will recognize capital gain on the land of 50k.

You will recapture 255k at up to 25%.

You will recognize capital gain on the building of 200k at capital gain rates.

At this point you are looking at 505k in income. And deducting 205k in losses. Those losses can offset the tax on your wages which could be(Probably are)  taxed at higher rate.

The key is the difference in tax rates.

-Steven

Passive loss carryover, should it be minimized?

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