Passive Activity Loss Limitation
Greetings, I'm a first timer looking to get into the rental property business. I'm out in California (read $$$ properties), and expect quite a few of those initial years for this venture to generate a passive loss. Unfortunately, my AGI is above $150K which means zero of my passive loss is deductible against my earned income.
I am thinking to refinance and cash out my own home (i.e. the primary mortgage, not get a second home loan, not a equity loan), use that cash to purchase the rental property. Then the rental business could fully apply all taxes, insurance, depreciation against the rental income and come out either zero or slightly profitable. My refinanced mortage's interest on my own home would be deductable against my earned income.
Anyone see something wrong with my idea? Also open to any other ideas on how to avoid carrying forward passive losses. Thank you in advance... Tom
Hello,
I got into rental units using the same strategy, but I'm not in the 150k/year range, so I could write off up to $25,000.00 in passive losses. In your case, you'll have to show that you "materially participate" in RE by: spending more than 750 hours per year on RE, AND spending >50% of your "professional service" time doing real estate. I purchased a great course froma CPA named Albert Aeillo, in it he has some forms that you can use to get around the passive loss limitations if you spend enough time doing real estate.
Overall, your plan sounds good. Being able to write off passive losses would just be icing on the cake. Best of luck to you.
Ted
Tom,
This is a remarkable coincidence, but I just addressed a very similar question with my tax preparer this afternoon.
My situation is very similar, the only difference is that I used a HELOC secured by my personal residence last year to buy a preforclosure. I am in the process of trading the preforeclosure under a 1031 exchange. I have expensed the HELOC interest against the property and it dawned on me that perhaps I should just deduct the HELOC interest against my personal residence where it would not be subject to the passive loss limitation.
My tax guy said that there is tax code that relates to the purpose of the loan and that I may be on thin ice if I were audited even though the loan is secured by my personal residence.
You might run this one buy a tax professional before you continue, and I will be interested in hearing if find out anything different from what I just heard today.
Regards and welcome to TCI,
Ed
Greetings Ed, I ran the same question by a tax forum and got about the same answer as your tax guy gave you. Basically, even if I refinance and cash out my own house, that any cashout amount is considered a home equity loan. And that would be subject to 100k max principle whose interest I could deduct on Schedule A. And even that home equity loan interest deduction could be cancelled due to AMT. But I haven't found the actual tax code that documents this yet.
Since you're also from the bay area, you know how expensive properties are around here. I'll be way negative cash flow for 5-10 years no matter what rental property I buy. And for that whole time I have to carry passive losses forward?!?! I'm questioning whether rental property investment in this market is worthwhile... :-(
I wouldn't take anything that was negative cashflow but that's just me.
As far as being classified as a real estate professional which allows you unlimited deductions (instead of 25k), I believe you have to show the 750 hours AND that the majority of your MONEY comes from real estate. I could be wrong but that's what I recall.
Ray Higdon
There are actually two ways to make money in real estate. Most of the talk is about the "finding a bargain" way (although any building with negative cash flow is not just fully priced, its over priced).
The other way is to "add value." Even in the hottest market in the fanciest neighborhood there are opportunities to add value.
But I suspect that your situation is such that trying to acquire and manage property is not really a good investment decision. I have an investor who is a big shot with a major corporation and makes big dollars there, but with pretty severe demands on his time and energy. For Bruce to take time to look for properties would mean a cut in pay.
Yet Bruce wants to get some part of his investment portfolio out of company stock and into real estate.
So Bruce and I team up. I find the deals, do the work add the value. Bruce puts up the money. Occasionally we talk and share ideas about the business. But mostly he keeps to himself, I do my thing, occasionally we buy or sell and he always gets input at those decisions.
You might look around. There are lots of REI types here and elsewhere who would be glad to partner with you. Together you may be a stronger team than either of you alone.
I would say your logic sounds good overall. IRC Reg Sec 1.163-8T does allocate interest expense according to what it's used for. However, 1.163-8T(m)(3) states that these allocation rules do not apply to qualified residence interest: "Qualified residence interest (within the meaning of section 163(h)(3)) is allowable as a deduction without regard to the manner in which such interest expense is allocated under the rules of this section. In addition, qualified residence interest is not taken into account in determining the income or loss from any activity for purposes of section 469 or in determining the amount of investment interest for purposes of section 163(d). The following example illustrates the rule in this paragraph (m)(3):
Example
Taxpayer E, an individual, incurs a $20,000 debt secured by a residence and immediately uses the proceeds to purchase an automobile exclusively for E's personal use. Under the rules in this section, the debt and interest expense on the debt are allocated to a personal expenditure. If, however, the interest on the debt is qualified residence interest within the meaning of section 163(h)(3), the interest is not treated as personal interest for purposes of section 163(h)." As you mentioned, there are other limitations to qualified residence interest but those apply to all home loans regardless of their use. I would run the details by your CPA, perhaps a different one than you've already talked to.
I found some solid documentation in IRS publication 936 which states:
Refinanced home acquisition debt. Any secured debt you use to refinance home acquisition debt is treated as home acquisition debt. However, the new debt will qualify as home acquisition debt only up to the amount of the balance of the old mortgage principal just before the refinancing. Any additional debt is not home acquisition debt, but may qualify as home equity debt (discussed later).
So my scheme would not work. Say if my primary mortgage is $400K, and I refinanced pulled out an additional $400k for a total loan amount of $800k. Only the first $400k, the amount needed to payoff my old loan, is treated as home acquisition debt and the interest is fully deductible. The second $400k which I would use to buy a rental property would count as home equity debt, of which only the first $100k is deductible. This would not apply if I could treat my new purchase as a 2nd home, but then I run into the problem of having to occupy it for a certain amount of days during the year.
I'll have to reconsider what kind of investments would be most advantagous to our tax situation and future goals. I don't know if any of you have worked in high tech, but it's a rat race, and even if you win, you're still a rat! That's what started me looking into way to become financially free enough to not work a day job in the next 10-15 yrs.
Hi there,
Using the $800k example, what if you do your refinance, take advantage of the $400k original and the $100k above that, then loan the rest to a, your, corporation who purchases the rental property, but who is unable to repay the note as outlined because of the negative cash flow, and you in turn show a loss on the loan. Seems like this would be legitimite. But I'll admit tax planning isn't my cup of tea. There's probably a good book out there outlining a good strategy for you.
I briefly read this thread and have a long shot possibility
Good luck,
Terry
engt,
Even though you are eligible to claim a home mortgage interest deduction for up to $500K on your cash our refinance, I would think that in your income range your itemized deductions would be subject to reductions and income limitation caps that might make the interest deduction unusable on that extra $100K .