Among all the other tax changes contained in the infrastructure bill and Build Back Better Act, one lesser-known provision could have potentially significant tax consequences for real estate investors and owners. Real estate professionals have enjoyed the benefit of taking unlimited losses on rental real estate activities. That benefit seems likely to be substantially reduced, and much sooner than those in real estate may be aware.
Current Tax Rules for Rental Real Estate Losses
Rental real estate properties can easily incur a loss even if the property generates positive cash flow. Operating expenses, depreciation, and other expenses can create a loss for tax purposes. This isn’t necessarily a bad thing; however, a net loss generally means a lower or negative tax liability and can even be carried forward.
Because rental real estate losses are passive, they can only offset passive income, like income from another property. Certain rental real estate owners and investors currently can deduct up to $25,000 of passive losses against ordinary income, like wages in a W-2. This is only applicable if modified adjusted gross income is $100,000 or less, with a full phaseout at $150,000 regardless of filing status.
There is another exception: the real estate professional status. If the taxpayer is a real estate professional in the eyes of the IRS, he or she may take unlimited passive losses from rental real estate against ordinary income.
Revisiting the Real Estate Professional Definition
From our previous article:
“To qualify as a real estate professional, the taxpayer must perform at least 750 hours of services during the year on activities directly related to the real estate business and have at least 50 percent of their work in these activities. Closely held businesses can qualify as real estate professionals if at least 50 percent of the gross receipts for the tax year come from real estate activities.”
Real estate investors or owners must also prove material participation to meet the real estate professional status.
Even if a taxpayer meets this status, it’s still possible he or she could not deduct unlimited losses. The Tax Cuts and Jobs Act put an income ceiling on taking unlimited business losses from passive income. Since 2018, the cap has been $250,000 for single filers and $500,000 for married filing jointly. Any losses above those amounts would need to be carried forward.
That limitation was scheduled to sunset after 2025.
Limitation on Loss in Build Back Better
The Build Back Better Act has proposed to permanently disallow excess business losses for non-corporate taxpayers. Real estate investors and owners – and bona fide real estate professionals – fall under this umbrella. As it’s written, this change would take effect in 2022.
Under the new rules, losses would be disallowed under certain amounts: $250,000 for single filers and $500,000 for married filing jointly. These numbers are adjusted for inflation each year, so in 2022 any rental real estate losses in excess of $524,000 for married couples would be disallowed.
In those cases, excess business losses could no longer be used against the taxpayer’s ordinary income. Instead, excess losses could only be applied to income or gain from a trade or business, either the one with the losses or another business.
For real estate investors and owners who exceed the loss limitation threshold, it will be like repealing the real estate professional status. It won’t matter when losses are high enough.
Other Potential Impacts of the New Limitation on Loss Rules
It’s not just real estate professionals who actively participate in a rental real estate business who will be affected. Even those who materially participate in a non-rental business would be prevented from using non-passive losses against ordinary or investment income. Again, losses – either passive or active – could only be taken against business income.
Further, passive loss that’s freed up when the corresponding passive investment is released would also be subject to the same limitations. That could create scenarios where the loss would provide no taxable benefit at all.
The bottom line: losses from one activity could no longer be used to offset income in another.
Changes Coming Soon
Build Back Better has moved back to the Senate for a final vote, which is expected in December. Any changes to the House version, and the legislation will need to go back to the House for another vote. It’s likely the bill will be voted on before the end of the year, but nothing is ever guaranteed with federal legislation until it’s final.
If passed as written, real estate professionals and other non-corporate taxpayers would be subject to the new limitation on losses in taxable years beginning after December 31, 2020. In other words, the change would be retroactive to 2021.
PBMares will continue to monitor these and other ongoing developments in federal legislation. Real estate clients are encouraged to meet with their real estate advisor prior to year-end to discuss tax planning strategies.