Convert Passive Income Loss To Active Loss
Hi, I am a newbie in the REI. I am considering buying a rental property in the San Francisco Bay Area. Because of the high housing price in the area, I wouldn't be able to use the rental income to cover the mortgage (not anywhere close).
I am mainly looking at using that passive loss to deduct my primary salary income. Since my primary income is close to $150K, I was very close to the phaseout limit.
My wife is planning to work in the real estate business, primarily as a loan agent (possibly also work as a real estate agent), does that qualifies her to be a real estate professional so that we can convert the passive loss to active loss?
And since we are filing the joint tax return, as long as my wife qualifies as the real estate professional, can we both enjoy the tax deduction?
IRS Publication 925 says this about the real estate professional status: "Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. " Since she will most likely work for a real estate broker or a loan company, will that be a problem?
About real estate professional status, IRS publication 925 also says this: "If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding requirements. However, you can count your spouse's participation in an activity in determining if you materially participated. " Can we still file the joint return and deduct the tax?
The real estate professional status is based on hours that are performed in real estate functions. You must spend more time in real estate activities than in any other activity for which you are compensated.
So if you are filing jointly and your spouse spends most of his or her activities real estate related you can offset paper losses form your other income, but their are many rules to the game and you should seek the advise from a good accountant that understands the realm of real estate.
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Thanks John for the explanation.
My wife will start her real estate career, so the # of hours or the majority of the time on real estate is not an issue. The one concern is that she will still be working for an real estate company, in order to qualify for the tax benefit, does she need to open her own real estate company or brokeage firm? (The IRS rule seems requiring owning at least 5% of the company.)
hcai
What is her status with this company?
Employee?
Independent contractor?
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John,
Well, all is just in planning yet, my wife is only at the stage of passing the real estate certification exam yet. Some of our friends are going into real estate business by working as a load agent or real estate agent, I think they are just working as an employee for a loan agency or real estate brokage firm.
Can you be an independent contractor and work for those companies? Do you need to buy some extra insurance to cover your real estate business (such as potential lawsuit/liability on real estate transactions)?
hcai
Question: Can you be an independent contractor and work for those companies?
Answer: Sure you can!
Question: Do you need to buy some extra insurance to cover your real estate business (such as potential lawsuit/liability on real estate transactions)
Answer: Most definitely if you are an independent contractor! If you are an employee most likely, the employer will have the insurance coverage needed.
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I am not sure about California law, but real estate agents are considered independent contractors even though they are sponsored by a brokerage firm. To make things even sweeter, in Illinois a real estate agent an form an S-Corp and have their sponsoring broker pay the compensation out to that S-corp(of course, some limitiation exist, such as the agent has to be the sole shareholder of the S-corp). So, if your wife will be a real estate agent, you don' t have to worry about a thing with IRS.
Consult a licensed tax professional before you undertake this investment strategy. It is true that a real estate professional can convert net passive losses to active losses and offset other ordinary income without regard to the passive loss limitation cap.
The flip side of converting passive losses to active losses is, when you sell the rental property, your sale profit is now also ordinary income -- you forfeit capital gains tax treatment on the sale profits.
Thank you all for the information.
NewKidInTown2 wrote, "The flip side of converting passive losses to active losses is, when you sell the rental property, your sale profit is now also ordinary income -- you forfeit capital gains tax treatment on the sale profits."
Can you elaborate more on this issue? Does it mean even if I hold the rental house for more than 2 years, the profit from selling the house wouldn't qualify for the long term capital gain (that's 15% tax rate today)?
Exactly. According to "The Real Estate Investors Tax Guide" by Vernon Hoven, if you treat the passive losses as active losses, then you also have to treat the income and profits on the sale as active income. No capital gains tax treatment on active income.
Thanks a million. I probably should take a look at Vernon's book before I make any decisions.
i would recommend vern hovens real estate taxation material to anyone and everyone.