Tax Code Trickery – Passive vs. Active vs. Material Participation
Prosperity Real Estate Advisors Management knows the devil is in the tax code details, and we intend to keep him at bay. One way that we protect our clients is by including them in the management of their property in a manner sufficient for them to be considered an “active participant” by the IRS. You see, rental real estate is a “passive activity” by default, and generates passive income or losses. If certain criteria is not met, passive losses can only be used to offset passive income…they can’t be used to offset non-passive income such as a W-2 job. To simplify this further. Joe Baggadonuts has a rental house and a job. Joe made $100,000 at his job cutting out donut holes at the donut shop, but he has a terrible and authoritarian rental management company which lost $10,000 on his rental property. This is bad for Joe, because Joe will have to pay income tax on his full $100k salary, without being able to deduct the $10k he lost on his rental. Joe’s only option is to carry his $10k loss forward into the next tax year, and apply it to any rental income he might have then. Sorry Joe.
Now take the same scenario and replace Joe’s terrible property management company with Prosperity Real Estate Advisors Management. Even though Prosperity Real Estate Advisors Management handled all of Joe’s late night plumbing maintenance, his tedius bookkeeping, his leasing and screening activities, his compliance and code issues…Prosperity Real Estate Advisors involves him in key decisions, so the IRS views Joe as an active participant. Now Joe is able to offset his $10k losses against his job income. What are those key decisions? Prosperity Real Estate Advisors involves Joe on tenant approval, rental terms, repair items, and capital expenditures, just like Joe likes.
Like all IRS’s rules, there are other rules that also come into play here, one of them being MAGI, or Modified Adjusted Gross Income. Joe can deduct $25,000 of passive losses against non-passive income as long as Joe makes less than $100k. Above that, the $25k deduction limit is phased out by $1 for every $2 over $100k in MAGI, and filing statuses affect these limits too.
Material participation is a different, much higher bar than active participation, and one that very few non-real estate professional landlords will be able to meet. We’ll cover this at a later time, but for now, rest assured that Prosperity Real Estate Advisors clients will be able to meet the IRS’ threshold for active participation.
Now, go save some taxes.
