Ever feel like the saying “death and taxes” is really coming true for you each year? Do you want ways to reduce your taxable income but that 401(k) contribution and student loan interest deduction are not cutting it? Learn about $25,000 yearly in passive paper losses from real estate investing as a way to reduce your AGI.
The more money you make, the more taxes you will pay. Conversely, the less money you make, the less taxes you will pay. The number one way to reduce taxes is to reduce your income, specifically you are looking for (legal) offsets to your income. So what are the ways to offset your income? A quick online search will reveal some of the most common ones, some of which may already apply to you: contribute to your 401(k), claim student loan interest paid, take the standard deduction, or itemize your deductions. Common itemized deductions include mortgage interest on your primary residence, medical expenses, and tax preparation fees.
A way that I infrequently hear anyone talk about is pass-through losses from a real-estate business. Now, who wants losses? Sure, you don’t pay income on them, but they are losses, which means you lost money! Well that is not the case if those losses are paper losses. Paper losses are exactly that, they look like losses on paper but they are not losses in real life! Real estate is a great way to get passive paper losses and pass them through to your personal income.
“Paper losses look like losses on paper but they are not losses in real life! Real estate is a great way to get passive paper losses and pass them through to your personal income. “
Passive losses for non-real estate professionals are capped at $25,000 a year. You can take the full 25k a year if your AGI before the losses was 100k or less and take a portion of them with an AGI between 101-150k. You’ll be able to offset your income from your W2 job by 25k a year using paper passive losses. That is more of an income offset than contributing to your 401(k)!
Okay, so how does this actually work? What is a paper passive loss from real estate? Seek the advice of a real-estate savvy tax professional but I’ll give you the basics here. You will pass the losses through using either the K-1 that is issued by the LLC you own that owns your real estate or a Schedule E. If you are not intimately familiar with tax forms, just read for concept below (see Line 17 of Form 1040).
Example: Your LLC buys a home that needs renovations. The home has good bones but has a lot of deferred maintenance. You go in and paint the walls, replace all the flooring, get new appliances, and replace the roof at a total cost of 22k. Then you put in your portfolio as a long-term rental. You also had to advertise the property and pay a property management company totaling 3k for the year. Now it generates cash-flow for you every month after all your expenses. Where are the losses in that? All those renovations are losses, even though they increased the value of the property! Additionally the home is a rental so that means that you get to depreciate it over it’s useful life of 27.5 years. So you get to claim 1/27.5 the value as a depreciation as a loss as well. You can up this amount by doing a cost segregation study. Paying for advertising and property management, that is also a loss. Those property taxes and mortgage insurance you paid, all losses. So all told let’s say you had 35k in losses on that property. Your LLC issues you a K-1. That K-1 shows all those losses. Those losses are used first to offset the income you got from cash-flow, then used to offset the W2 income you got from your job.
As mentioned previously you are capped at offsetting 25k of losses against your W2 income. If you were going to have an AGI of 100k you just reduced it to 75k. With this passive loss, you just saved $5,850 in federal taxes by doing this, all while building assets. The other benefit is that all that passive income from cash flow can also be offset by losses, making it tax free.
This is particularly important if you have student loans slated for forgiveness if you work for the government or a non-profit. Your annual loan payments are set by this AGI. So the lower your AGI is, the less you pay on those student loans.
What if your W2 income is over 150k? Well you can’t offset your W2 income with these losses. However, you can offset your passive income with those losses. So you can use the losses to offset all the income you make from rental properties. The end result is that income earned from investment real estate is tax free, even without the ability to reduce your AGI with losses above.
Okay, how can I actually do this?
Buy your own rental real-estate that needs some fixing up, or
Partner with someone else who wants to buy rental real estate that needs some fixing up and form an LLC with that person. You’ll be able to pass the losses through even though the other person is doing the work, or
Participate in a real estate syndication where you are a limited member, that LLC will issue you a K-1 and you’ll be able to claim the losses.
A few additional notes: It is best to buy at least one new property each year, since you usually only do those major renovations on the year you buy. However, if you need losses and have wanted to renovate something you already own, this could be the year. I hope this inspires you to look at passive paper losses as a way to reduce your taxable income!
Note: Please seek the guidance of a tax professional, this does not serve as legal or tax advice, this is something I use to reduce my own AGI.