Can Real Estate Investors Deduct Any Losses?

If you are a real estate investor or considering investing in real estate, you probably did not like the news that by default all real estate investments are considered to be passive activities.  As we previously discussed, you cannot deduct passive activity losses against "active" income, you can only use it to offset passive activity income if there is any.  However, there are exceptions to this general rule.  The first exception is for active participation in real estate investments.  If you qualify for this exception, you can deduct up to $25,000 of losses.

Only individuals, an individual's estate, or an individual's qualified revocable trust can actively participate in a rental activity.  You must also own at least 10% by value of all the interests in the activity throughout the year.

What does it mean to actively participate in the real estate activity?

Active participation is a fairly relaxed standard that can be met simply by making significant management decisions.  For example, this standard can be met by:

• Approving new tenants;
• Determining the rental terms; or
• Approving expenditures.

This is not an exhaustive list, so other similar decisions could be enough to qualify as active participation.

However, even if you actively participate in a real estate activity you may not be able to deduct the $25,000.  The $25,000 "special allowance" phases out based upon your income.  For every dollar of income you earn over $100,000 the special allowance decreases by $0.50 until it is completely phased out at $150,000 of income. 

If you would like to know more about the active participation exception to the passive activity rules, please feel free to send me an e-mail.

How Do I Know If My Business is a Passive Activity?

In the last post, I discussed the consequences of having your business be classified as a passive activity.  As I mentioned, any trade or business activity in which you do not materially participate is a passive activity to you.  But how do you know if you have materially participated?

Image borrowed from www.123rf.com

Luckily for you, there are 7 tests that answer this question, and you only need to "pass" one of them to avoid the "passive activity" treatment.

The material participation tests are:

1) You participated in the activity for more than 500 hours.  In general, any work you do for the business counts, unless it is the type of work not customarily done by the owner of that type of activity or your main reason for doing that work is simply to reach 500 hours.

2) Your participation was substantially all the participation in the activity of all individuals for the year, including participation of employees.  In other words, if you essentially run the business by yourself you do not have to worry about the number of hours you actually worked.

3) You participated in the activity for more than 100 hours during the year, and you participated at least as much as any other individual.

4) You participate in multiple trade or business activities, each for at least 100 hours, and combined they add up to more than 500 hours.  However, each activity in this grouping must be (if looked at individually) a passive activity.

5) You materially participated in the activity for at least 5 of the last 10 years.

6) You materially participated in a personal service activity for at least 3 years (regardless of how many years ago that was).  For these purposes, personal service activities include activities in the fields of health, law, accounting, or consulting, or any other activity for which your personal skills/services (not capital) is the primary income-producing factor.

7) An evaluation of the "facts and circumstances".  This is the least certain of all the material participation tests because you have to evaluate your situation and make a decision as to whether you materially participated, and hope that the IRS agrees.

If you satisfy any one of these tests, then you materially participated in your trade or business and are entitled to deduct the losses against your other income.

Please keep in mind that your real-estate related activities are considered to be passive activities regardless of whether your materially participated in them.  However, there are two exceptions that we will be discussing in the next blog posts.

If you have any questions about the passive activity rules and how they affect you, please send me an e-mail.

What Do You Mean My Investment is a Passive Activity?

Has anyone ever told you that your investment in a business or in real estate is a passive activity?  Do you know what that means?  Don't worry, most people don't.

Before 1986, investors would create tax shelters for themselves by putting their money into investments that would generate tax losses but no actual economic losses. For example, they may invest in a rental property and then would rent the property to a tenant for an amount equal to the monthly expenses. The investors would then have no net cash inflow or outflow, but would be able to depreciate the property and claim a tax loss.


Congress eventually caught on to the games that investors were playing with the Tax Code as it existed back then, and as a response invented the passive activity rules.

Under the passive activity rules, there are two types of passive activities.  The first type of passive activity are trade or business activities in which you do not materially participate.  In the next blog post we will discuss how this is determined.  The second type of passive activity are rental activities (although there are two exceptions that will be discussed in future blog posts).

The income and gains on passive activities will continue to be taxed just like any other ordinary income and gains. However, the losses on passive activities are not deductible but instead can only be used to offset passive activity income.  The passive activities losses are deferred until they can either offset passive activity income or the underlying investment is completely disposed of (e.g., sold).

In addition to not being able to deduct passive activity losses against your active income, the passive activity income is subject to the 3.8% Medicare Surtax.

Do you think you might have a "passive activity" investment?  If you would like to discuss whether it truly is a passive activity and how that affects your taxes, please send me an e-mail.

S-corp vs. LLC: Allocation of income and losses

As you have now discovered, there are a number of differences between S-corporations and LLCs. S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to follow are far more relaxed.  There are also differences in the taxes and fees that they have to pay to California, and the types of compensation that the owners of each can take. The amount of flexibility you have in allocating income and losses between the owners is also a key difference.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage.  Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation's taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

If you have questions about the tax differences between S-corporations and LLCs, or if you would to talk about the requirements necessary in order to have non-proportional allocations in your LLC, please send me an e-mail.

S-corp vs. LLC: Income

In last week's blog, we discussed how California taxes S-corporations and LLCs differently.  In this blog, we will be discussing the differences in how the owner's compensation is classified.

Image borrowed from
www.nanohealthtechnology.com

The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. While they will be discussed in more detail in a future post, it is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.

On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways.  The first, like LLC members (owners), is through ownership distributions.  These are withdrawals of the business' profits.  The second method, which is not available to LLC members, is through a salary.  In fact, an owner-employee of an S-corporation is required to take a "reasonable salary" before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business.  The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions.  This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business.  You could, for example, take out $20,000.  However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.

An S-corporation's net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.

Regardless of whether your business is structured as an LLC or as an S-corporation, the business's profits are passed through to the owners and subject  to income taxes.  They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.

If you would like to know more about the differences between S-corporations and LLCs and how it can affect your taxes, please send me an e-mail.

S-corp vs. LLC: CA Minimum Taxes

Besides the formalities that S-corporations have to observe, there are a few other differences between S-corporations and LLCs.  One difference that will affect your bank account is how California assesses taxes.

Image borrowed from www.alliancetrustcompany.com

The amount of California taxes that an S-corporation will pay is based upon its net income.  An S-corporation pays the greater of $800 or 1.5% of its net income.

An LLC, on the other hand, pays $800 of California taxes and may be assessed an LLC fee based upon its revenue.  The table below shows the LLC fee for the various revenue ranges.

Revenue	LLC Fee
$0 - $249,999	$0
$250,000 - $499,999	$900
$500,000 - $999,999	$2,500
$1,000,000 - $4,999,999	$6,000
$5,000,000 +	$11,790

Therefore, whether an S-corporation or an LLC makes more sense for your business (based purely on the amount of taxes you will pay to California) depends on what you expect you revenues to look like compared to your net income.  Lets look at a few examples.

Example 1

You expect your business to have $600,000 of revenue but only $60,000 of net profit.  In this case, it makes more sense to operate as an S-corporation.  As an S-corporation you would be paying $900 in taxes to California ($60,000 x 1.5%).  However, as an LLC you would pay $3,300 ($800 of taxes plus a $2,500 LLC fee).

Example 2

You expect your business to have $900,000 of revenue and $300,000 of net profit.  In this example, it makes more sense to operate your business as an LLC.  As an LLC, you will be paying $3,300 to California ($800 of taxes play a $2,500 LLC fee).  However, as an S-corporation you would be paying $4,500 in California taxes ($300,000 x 1.5%).

If you would like a further understanding of the tax differences between LLCs and S-corporations, please send me an e-mail.

Can You Own an LLC By Yourself?

Sometimes the number of owners a business has affects what types of entities it is allowed to operate as.  While a corporation can have one or more owners (shareholders), a partnership by definition must have two or more owners.  An LLC can be thought of as a hybrid between corporations and partnerships, so can it have only a single owner (member)?  It depends.

Image borrowed from www.corporatedirect.com

The federal government's position changes depending upon how an LLC elects to be taxed.  LLCs have the option to be taxed as either a corporation or a partnership, but the default rule is that LLCs are taxed as partnerships.  If a single-member LLC elects to be taxed as a corporation, then the federal government will recognize the LLC as a corporation. However, if a single-member LLC elects to be taxed as a partnership, then the federal government will treat the LLC as a "disregarded entity".

The federal government essentially creates a legal fiction that the disregarded entity does not exist. It looks through the disregarded entity and attributes all of the entity's actions to its owner.  The owner is required to report the entity's income on its own tax return.

California, however, does not treat a single-member LLC any differently than any other LLC.  The LLC is required to file its own tax return for California.  In addition, because LLCs are created under state law, a single-member LLC has all of the same legal protections that any other LLC would have, such as limited liability protection.  If you would like a better understanding of a single-member LLC's legal rights, I would recommend talking to a business law attorney.

If you have any questions regarding how a sigle-member LLC is taxed, please send me an e-mail.