Real estate tax planning often focuses on generating deductions. Strategies such as accelerated depreciation or cost segregation can create significant deductions earlier in a property’s life, potentially improving cash flow.
But there’s an important second question to ask:
“Can you actually use those deductions right now?”
For many real estate owners, passive activity loss rules can limit the answer. Understanding those rules can help you evaluate a tax strategy based not only on the size of the deduction it creates, but also on when that deduction may provide a tax benefit.
Why a Deduction May Not Reduce Your Taxes Today
Under federal tax rules, rental real estate is generally considered a passive activity. In general, losses from passive activities can offset passive income, but they cannot automatically be used to offset nonpassive income, such as wages or income from a business in which you materially participate.
That distinction can become especially important when a tax strategy creates a large loss. For example, imagine a real estate owner completes a cost segregation study that significantly accelerates depreciation deductions. On paper, the property may generate a substantial tax loss. However, if the owner does not have enough passive income or qualify for an exception to the passive loss rules, some or all of that loss may be suspended rather than deducted in the current year.
In addition, passive losses don’t offset portfolio income such as interest, dividends, or capital gains from mutual funds or stocks. The deduction still has value, but it may not create the immediate tax savings the owner expected.
What Happens to a Suspended Passive Loss?
A loss limited by the passive activity rules generally is not lost. Instead, the disallowed amount carries forward to future tax years. It may become deductible when the taxpayer has sufficient passive income or, generally, when the taxpayer disposes of their entire interest in the activity in a qualifying transaction.
That makes timing an important part of the planning conversation.
Accelerating $100,000 of depreciation can look attractive, for example, but the benefit is different if most of that deduction will sit suspended for several years. Before pursuing a strategy primarily for its upfront tax savings, owners should understand how much of the resulting loss they may be able to use.
In some situations, creating a passive loss is helpful if a taxpayer is considering selling a property in the future. The losses generated can help offset the gain on the sale of a future property. Tax planning oftentimes involves more than just evaluating the current year when it comes to passive losses.
Are There Exceptions?
Yes. One limited exception allows some taxpayers who actively participate in rental real estate to deduct up to $25,000 of rental real estate losses against nonpassive income. The allowance is subject to income limitations and other requirements.
Another important consideration is real estate professional status. Rental real estate activities in which a qualifying real estate professional materially participates may be treated as nonpassive.
Those rules become particularly important for owners with multiple properties, LLCs, or partnerships because the treatment of each activity (and the owner’s participation in it) can affect whether losses are currently usable. We will explore those considerations more closely in our next article on real estate professional status.
Look Beyond the Size of the Deduction
Passive loss rules are a good example of why real estate tax strategies should not be evaluated in isolation. Before completing a cost segregation study, making a major acquisition, or planning another transaction, consider not just, “How large will the deduction be?” but also, “How much of that deduction can I use, and when?”
For Wisconsin real estate owners with multiple properties or entities, that broader view can help determine whether a strategy creates meaningful value for the overall tax position rather than just a large deduction on paper.
Before buying, renovating, restructuring, or selling real estate, talk with a Wegner tax advisor about how these strategies may interact across your entities.
