For many years, investing in real estate has been a common way to generate passive income. Yet, a lot of investors aren’t aware of passive losses or how they can hurt their bottom line. We’ll go over what passive losses are in this blog post and how they function when it comes to real estate investing.

What are Passive Losses?

When an investor suffers losses through a passive activity, like renting out a house, but is unable to deduct those losses from their taxable income, that situation is known as a passive loss. Since the investor is not actively involved in the property’s day-to-day operations, the IRS views rental properties as passive activities.

How do passive losses work in real estate investments?

Passive losses in real estate investments often come from three different places:

1. Depreciation: Through this tax break, landlords can gradually recoup the cost of their rental properties. The IRS permits property owners to write off a part of their acquisition costs annually for up to 27.5 years for residential properties and 39 years for commercial properties. Depreciation is not a real expense in money, but it is treated as a loss for taxation.
2. Operational Expenses: The costs related to maintaining a rental property, including insurance, upkeep, repairs, and management fees. These costs can be subtracted from rental income, but if they are higher, the excess is regarded as a passive loss.
3. Mortgage Interest: The interest owed on a loan for a rental property. Mortgage interest can be deducted from rental income similarly to operating expenditures, but if the interest exceeds the rental income, the excess is regarded as a passive loss.

How are passive losses calculated?

Passive loss calculations are rather simple to perform. The investor begins by figuring out their rental income, which is equal to the total rent collected from the property less any operating costs. In order to arrive at the rental revenue, the investor first deducts any mortgage interest. Passive loss is what is implied if the outcome is negative.

Let’s take the case of an investor who owns a rental home that brings in $30,000 a year in rental income. The property has $20,000 in running expenses and $15,000 in mortgage interest payments. The investor would compute rental revenue as follows:

Rental income = $30,000 – $20,000 = $10,000

Passive loss = $10,000 – $15,000 = -$5,000

In this case, the investor experiences a $5,000 annual passive loss.

How are passive losses treated for tax purposes?

In general, passive losses cannot be deducted from an investor’s taxable income. There are a few exceptions to this rule, though.

Secondly, an investor may be allowed to deduct up to $25,000 in passive losses from their taxable income if they actively participate in the rental property. The investor must meet certain requirements, such as owning at least 10% of the rental property and actively taking part in its management, in order to be eligible for this deduction.

Second, an investor may be able to deduct a loss from their taxable income if they sell a rental property at a loss. A capital loss is a tax deduction that can be used to offset any capital gains the investor may have made in the same year.

Finally, an investor may be able to carry forward passive losses to future years if they have losses that they cannot write off in the current year. Losses may be carried forward forever until they are offset by passive income or the property is sold, whichever comes first.

An investment in real estate may suffer major financial consequences from passive losses. Investors who wish to maximize their profits and reduce their tax obligation must comprehend how passive losses operate and how they are considered for tax purposes.

By actively managing their rental properties, investors can reduce their exposure to passive losses and potentially deduct up to $25,000 in losses from their taxable income. Investors can also think about hiring a tax expert or accountant to guide them through the intricate tax laws governing real estate transactions.

Ultimately, even though passive losses can be difficult to comprehend, they are a crucial component of real estate investing and shouldn’t be disregarded. Investors who take the time to understand passive losses and how they operate will be better able to make decisions that will help them reach their financial objectives.

F2H Capital Group is a debt advisory firm specializing in negotiating the best terms for your commercial real estate projects. The company offers a range of financial products and services, including fixed loans, bridge loans, and construction loans across all asset types. Please contact us for any of your financing needs.