If you think you can shelter all your ordinary income, such as wages, interest and dividends from income taxes by investing in depreciable real estate, such as apartments, offices, stores or rental houses, think again. The 1986 Tax Reform Act killed real estate as a major tax shelter--except for the small investors.
If you earn less than $100,000 annual adjusted gross income, you can deduct up to $25,000 of losses each year from your passive-loss realty investments.
Between $100,000 and $150,000 adjusted gross income, your tax loss deductions are gradually phased out at the rate of $1 for each $2 of income over $100,000.
If you earn over $150,000 adjusted gross income, forget about deducting your real estate tax shelter losses unless you invest in low-income housing.
Recently, several major real estate syndication firms have become unable to pay their bills as they come due. Why? Because they haven't been able to sell their properties, such as office buildings and apartment complexes for the increased market values they were counting upon. Potential buyers just aren't interested, primarily due to the lack of a tax shelter.
Most experts attribute the depressed prices for large investment properties to the 1986 Tax Reform Act, which discourages wealthy investors from buying depreciable real estate. In addition to the maximum $25,000 annual passive loss deduction, if your adjusted gross income is less than $100,000, the rules require depreciating residential rental property over at least 27.5 years and commercial properties over 31.5 years. Depreciation is a non-cash tax deduction for estimated wear, tear and obsolescence.
However, the news about passive-loss deductions is not all bad. If you have annual passive-loss deductions that you cannot use, you can "suspend" them for future use. IRS Notice 88-94 says passive losses from an investor's rental activities, taken as a whole, can be used to offset profits from property sales. This means that the IRS says rental property losses can be used to shelter profits from property sales. Some tax advisers previously thought losses and gains had to be offset on a property by property basis.
The 1986 Tax Reform Act says all income and expenses from rental property are "passive" no matter how much time or money the owner spends managing the property. Even when out-of-pocket cash losses result, except for the maximum $25,000 annual loss deduction, passive activity losses must be saved for possible future use. This lack of immediate tax deductions discourages investors from tying up their money in real estate investments.
Three basic rules apply to real estate passive investments:
1--Investors who own less than 10% of a property, partners who own less than 10% of a limited partnership and owners who do not materially participate in managing their property cannot qualify for passive loss deductions. Material participation is considered to be involvement in major management decisions, even if a property manager handles the day-to-day property supervision.
2--Owners who materially participate in managing their property qualify for up to $25,000 of annual passive-loss deductions against their ordinary income. This "small investor exception" to the disallowance of passive-loss deductions phases out at the rate of $1 for each $2 of adjusted gross income over $100,000 ($200,000 for investors in qualified low-income housing).
3--Until the $25,000 maximum passive-loss rule phases in by 1991, 65% of passive losses were deductible in 1987, 40% on 1988 tax returns, 20% for 1989 and only 10% of 1990 property losses are deductible against the investor's ordinary income. With these limitations, the result is that more than $25,000 of annual passive losses can be deducted by investors until the end of 1990.
Just because most of the real estate tax shelter is gone doesn't mean real estate is a bad investment.