Offsetting Flipping Taxes with Passive Rental Income?

Question

So, I have read several books and posts on here concerning offsetting income tax with passive loses or depreciation from rental properties, but I am still a little unclear as to how that all works and if I can actually use use rental property losses or depreciation to offset my house flipping taxes.

Disclaimer: I am going to speak with an accountant and get some tax planning advice in April (soonest I can get an appointment), but in the mean time, I would like to start looking for rental properties now if it would benefit me this year.

More Info: Currently, I have a business that brings me about 100k income. It is set up as an LLC, elected as a S Corp. Currently, my salary is 30k and the rest is distributed in owner draws. This year, I expect to flip at least 10 houses if not more under another LLC, elected as an S Corp. Currently, I am on flip number 4 and it's March. From each of these houses, I should make between 15k to 20k. I tell you all this because I have read that there are certain stipulations on income level when it comes to offsetting your income tax.

By nature, my understanding is that flipping houses is considered active income, however, I don't do any of the work and I don't manage the projects. The most I do is look at the properties, put in offers, sign contracts and visit the job sites to make sure everything is running smoothly. Point is, I don't think I will even put in 500 hours into flipping houses this year, which I believe is one of the conditions for active income. The reason why I bring up this point is because I have read that in certain circumstances, you can only apply passive loses or depreciation towards passive income and not active income. Again, I am getting some conflicting information here, so I still don't quite understand how that works. So, if I am putting in less than 500 hours per year into flipping houses, can it be considered passive income? Also, If I were to buy rental properties, I would not be managing them myself, so the income from rental properties should also be passive.

So in a nutshell, can I offset my income taxes from both of my LLCs, by using rental property depreciation or losses from a different LLC? If so, how and what conditions have to be met?

J Scott · Answer

If you're doing a bunch of flips, the income you generate will be taxed as ordinary at your marginal rate (unless done out of a c-corp).  For rentals/buy-and-hold, you'll be taxed at capital gains rates.  It doesn't matter how "passive" or "active" you are in completing these activities, they'll be taxed as I indicated in the previous two sentences.

Now, the number of hours of active investing DOES apply to your status as a  "real estate professional."  If you work at least 750 hours in an active investing role, and you don't work more hours in any other business/job, you may qualify as a real estate professional.  And being a "real estate professional" does come with tax benefits.  Specifically, you have the ability to avoid passive activity loss rules set by the IRS.

What does that mean?  Typically, if you make less than $100K in real estate income, you can take up to $25K paper loss on depreciation.  But, if you make over $150K in real estate income, you can't take any depreciation loss.  (there is a phase out between $100-150K)

As a "real estate professional," the phantom loss of depreciation is not capped -- you can take unlimited losses.  Of course, if you don't own any rental real estate, and don't have any depreciation, this doesn't really help you.

Note that I'm not a tax professional, so don't rely on anything above as tax advice...

Nicholas Aiola · Answer

@Dean Ingraham

@J Scott is right on the money. You cannot use passive losses to offset active/other income. If you actively participate in your passive businesses (actively participating in a passive business is different than operating an active-income business), however, you can deduct up to $25k in passive losses per year against your other income, provided that you don't exceed the income threshold. It sounds like you will exceed this, though.

If you are a RE professional, as J described, the activities that were once considered passive (rentals) are now considered active, in which case you can use the losses to offset your other income (flipping income).

Your flipping hours count towards the 750-hour requirement to become a RE professional.

J Scott · Answer

First, a reminder that I'm not a tax professional...all my information comes from reading, talking to my tax professionals and dealing with these issues in my professional life...

To qualify for real estate professional status, this is what the IRS says:

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.

Don’t  count  personal  services  you  performed as an employee in real property trades or businesses unless you were a 5% owner of your  employer.  You  were  a  5%  owner  if  you owned (or are considered to have owned) more than 5% of your employer's outstanding stock, outstanding voting stock, or capital or profits interest.

And yes, you can use depreciation to offset other income, but the amount of depreciation you can use is going to be based on passive income rules.  This is where the real estate professional designation comes in -- if you are designated as a real estate professional by the IRS, you can use depreciation to take a larger loss than you would be able to if you didn't have real estate professional status.

See this for details:

https://www.irs.gov/pub/irs-pdf/p925.pdf

Dean I. · Answer

I guess what I am asking, is what tasks fall under that list? For instance, does looking for properties online for an hour fall under acquiring RE? Or does physically going out to potential investment properties with a Real Estate agent fall under acquiring RE? What about meeting with contractors or checking on the status of a rehab, does that fall under "develops or redevelops it" or "constructs or reconstructs it." What about drive time to acquire these properties or meeting contractors who are rehabbing them? Basically, which activities can I log, that will go towards those 750 hours?

Also, I am not sure what you mean by "Keep in mind, the RE pro text must be met for EACH property, unless you elect to aggregate them all as one activity." Does that mean that whatever I do that is RE related, it must fall under ONE of these items listed?

Nicholas Aiola · Answer

@Dean Ingraham exactly - a planner with a detailed time log is your best bet. Log EVERYTHING - the more specific and detailed, the better.

Yes, as a RE pro, your rental losses can be used to offset all other income.

Aaron Smith · Answer

Sounds like you could potentially have the perfect number of rentals in nice areas that don't cash flow that well (but should appreciate well over time), accelerate their depreciation with cost segregation, and have their losses perfectly balance out the flipping income. No taxes!

Dean I. · Answer

Oh, that makes more sense. So, house flipping several properties a year, would be aggregating my hours under one broad activity, instead of one specific property, right?

Nicholas Aiola · Answer

@Dean Ingraham that would be a topic to discuss in further detail with your CPA/tax advisor.

What I meant in the last post was RE pro test*. Apologies for the typo. Meaning you have to meet the 750 hour requirement for each property you own, unless you elect to aggregate.

Nicholas Aiola · Answer

@Dean Ingraham Publication 527 defines real property trades or businesses as this:

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.

Keep in mind, the RE pro text must be met for EACH property, unless you elect to aggregate them all as one activity.

Dean I. · Answer

Ok, one last question . . . . What is considered

" . . . . more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated?"

Looking at properties online (MLS, Auction Sites, etc), physically looking at properties in consideration, putting in offers, going to closings, meeting contractors, checking progress on projects, going to RE meets, going to RE seminars, driving time to these events and locations? I may be over thinking it, but it seems that becoming a RE Pro in the eyes of the IRS is in my best interest and I want to properly log everything and take advantage of everything I do RE related, if it counts towards those hours.

Thanks again for all your help!

Offsetting Flipping Taxes with Passive Rental Income?

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