Throughout the sayings of the wise King Solomon, houses are linked with wisdom, prudence and a prosperous life, as in the often quoted Proverbs 9:1, which says in part, “Wisdom hath built a house.” Today, too, houses and real property are considered a sign of prosperity and long-term stability. Though the Internal Revenue Service may not think in the same terms as the fabled King, the IRS does reward property ownership with a variety of credits and tax deductions. Among these is the write off for passive activity losses.
On tax returns, income and losses from all sources are divided into two types, passive and nonpassive. Nonpassive activities include businesses, enterprises and investments in which a taxpayer actively participates, through an investment of time and other material commitments. This category includes salaries, lottery winnings, pensions and investment portfolio income.
On the other side is passive income, derived from businesses and enterprises without material participation — and rental property. Limited partners and investors generally fall into this category, although there are qualifying standards that may allow others. Passive income derives from investments and activities that generally don’t involve active and regular hands on participation.
Although investment income from sources such as portfolios doesn’t generally qualify as passive activity, owning rental real estate does. Investors who choose to manage their own properties know the enterprise may be anything but passive — but for income tax purposes. Most rental real estate investments on the individual level do count as a passive source of income. Exceptions include the sale of undeveloped land or other unutilized investment property. The distinction between passive and nonpassive activity becomes relevant for income property investors in terms of income loss more than profit. That’s where deductions for passive activity loss come in.
As investors know, most expenditures related to the maintenance and management of rental income property are tax deductible. These include mortgage interest – a perk that survived the fiscal cliff crisis – travel related to managing the property, expenses connected with advertising vacancies, repairs and depreciation, and more. But under the provisions of Internal Revenue Code 489, taxpayers can claim a deduction for losses on passive income as well—in this case, in the event the property faces a loss of tenant income for a period of time during the relevant tax year, or other circumstances occur that prevent an investor from seeing a profit from the investment.
Tax experts warn that passive activity losses must be thoroughly documented and justified. But this tax break joins the numerous other deductions and exemptions claimed by investors in rental property – breaks intended to support individual investor-entrepreneurs rather than corporations or large investment groups. Since other kinds of investment income from stocks, bonds and other kinds of partnership are considered nonpassive income, being passive as an investor in income property– as Jason Hartman recommends — may be a smart activity indeed.
The Solomon Success Team