Passive Loss Deductions and Why You Should Rethink Your Investments

Before 1986, it wasn’t uncommon for someone to invest in a business or rental property that was designed to lose money. The logic behind this move: the tax benefits received from the investment far outweighed any loss that occurred. These “tax shelters” allowed investors to deduct the losses they incurred from other income they earned. In 1986, the story changed when Congress enacted the passive activity loss (PAL) rules, which limited an investor’s ability to offset their income with rental or business losses.

Understanding and categorizing income or loss as active or passive is important because passive losses can only be deducted from passive income, not from income earned in other ways. These types of income and loss can occur two ways: through a business’s investment you don’t materially participate in and all rental properties you own. Material participation is defined as one that you participate in on a day-to-day basis. The income or loss from a restaurant owner who actively runs the business is active, whereas the income or loss from a restaurant investor who spends no time working within the business is passive.

Let’s look at an example that involves the medical profession to gain a better understanding of how passive loss deductions can affect your investment choices.

Dr. Smith earns a $500,000 salary from his medical practice. He invests $35,000 in a real estate limited partnership. At the end of the year, Dr. Smith meets with his CPA for tax planning. He informs the CPA that his share of the partnership’s annual operating loss is $50,000. Dr. Smith’s goal for investing in the partnership was to use the passive loss of $50,000 against the salary earned through his medical practice. What Dr. Smith learns is that because his loss is passive through his real estate investment, he’s unable to deduct the loss from his active income at the medical practice. Dr. Smith has earned no other passive income for the year which means he’s unable to use his passive loss for this year.

The same holds true for investments beyond real estate where the investor holds a passive role. Working closely with your CPA to plan and implement strategies that will be worthwhile at the end of the year or in the long run is always a better approach. Contact us today; we’d love to discuss tax planning further.