What happens when you sell a rental - taxwise??

A question we often see among our retired or semi-retired clients is, "What are rental real estate passive activity losses and how do they affect me?"  This requires a short jaunt into the cloudy world of "Passive activity losses."  

The chances that you will experience passive activity losses are limited. There are only two activities that the IRS considers passive activities:   Rentals, including equipment rentals and rental real estate, and business interest in a sole proprietorship, partnership, S corporation or LLC., in which the taxpayer does not materially participate.   Material participation is described by the IRS as “regular, continuous, and substantial basis in operations.”  In other words, if you own rental real estate but are not a real estate professional and use a property manager like many investors do – then your participation is considered “passive.”

Generally, losses generated by passive activities can only be used to offset income generated by passive activities.   If passive losses are greater than your income from passive activities, then these losses are generally disallowed and are carried forward to the next taxable year so that they can be used to offset passive income at some point in the future.

So, let’s explore how this rule might affect the average client approaching retirement.  The most common passive activity we see among individual approaching, or enjoying retirement, is rental real estate ownership.  Even if the taxpayer does materially participate in the rental activity, by making the management decisions, it is still considered a passive activity by the IRS.  For rental real estate activities in particular, the IRS considers whether or not the rental real estate owner is “actively” participating which is a less restrictive standard than the material participation standard.  To be considered as actively participating, the taxpayer must own at least 10% of the rental property and must make management decisions in a significant and bona fide way.  If the IRS determines that the taxpayer did not actively participate, rental losses will be disallowed and carried forward.  You don’t lose them completely, you just don’t get to deduct them against other income when the losses happen.  They do carry forward and can be used in future years when your income is below the limit or when you sell the property.

Sooo…. If over the years I’ve accumulated a bunch of passive losses that I can’t use… what happens when I sell the property?

When you sell the property, you finally get to deduct all those losses on your tax return.  In other words - all the losses or gains are finally "realized" in that year and are resolved on your tax return for that year.  This can mean a great tax planning opportunity. Realizing the losses can help reduce the gain (if any) from the sale of the property and can possibly offset taxable income from other income sources.  It may provide additional opportunities to take advantage of other tax planning strategies such as ROTH IRA conversions or realizing other investment gains at a very low tax bracket.  It makes perfect sense to realize gains in an investment account at a zero capital gains tax bracket if possible - you can always buy the investment again is 31 days.  So... the moral of the story is that whenever you sell a rental property, make sure to look at your OVERALL financial situation to spot possible tax planning opportunities that may exist.  Don't simply look at the event itself in a vacuum.

Only with comprehensive planning, can you expect to truly optimize your tax mitigation strategy.  This is why we always suggest including your CPA AND your CERTIFIED FINANCIAL PLANNER(TM) professional before selling your rental property so you can take advantage of the opportunities that you have available. 

Ed Acker, CFP®, is a Client Service Advisor for Paragon Wealth Strategies, LLC.  Please see his bio here.