How to Claim a Capital Loss Tax Deduction for my Investment Property – Video
Skip: All right. Income classifications. This is something that it’s quite important and it’s actually rather complex. You’ve got overlapping categories and you’re going to get conflicting information about what these things mean.
Be careful, be particularly careful about getting tax advice from someone who is not professionally qualified. It happens all the time and most of it is very bad and can lead you down the wrong path. If you’re making decisions based upon what you think tax consequences are, be sure you’ve got good professional answers to your questions.
As to income classifications, ordinary income is your first initial broad classification. If it isn’t anything else specific, it’s ordinary income. People think of this as basically your wages. Your main income that’s coming into you, is ordinary income. You then have passive income and we’ll talk about that in a little more detail, but that is income coming from a source that where you don’t materially participate in that particular activity. It is an activity, it’s not just an investment. Your investment income, we’ll get to that in just a moment.
Capital gains. We’re all familiar with capital gains. You’re holding a capital asset, you sell a capital asset. If you held it for more than a year, you’ve got long-term capital gains, less than a year, short-term capital gains. Everybody’s pretty comfortable with that, I would think. We’ve talked about this briefly.
First thing is to offset your losses with your passive income. Let’s talk about the carry forward here for a moment. This is very common with real estate investors, particularly in the early stages, particularly if they’ve been very good about getting financing on their properties.
You’re generally going to be generating passive real estate losses, particularly in your early years. What happens with those losses? They don’t go away, they carry over. In fact, on Thursday night’s presentation, we had a question as to how long do those losses last. The answer is they never go away.
Your passive losses are always there. You have got to have a good accountant to make sure that they’re being tracked year after year after year, because they’re going to carry forward year after year after year. If somebody misses something in the middle, you can go back and pick it up but you have to know that it’s there to go find it. Just make sure you’re using good pros that are going to track this going forward for you.
It’s not like operating losses. If you have net operating losses, like you have a business that’s a disaster and you’ve been generating net operating losses year after year after year, that will only go for 20 years.
Well, if you’ve got 20 years in net operating losses, you’ve got bigger problems. Your passive losses can build and they will never go away. What are they, very quickly? No material participation.
Limited partnership investments are passive, you’re not actively involved in that business. If you want to have a limited partnership investment where you’re active, you’ve got to own 10% of it and you have to really be active. Some S corporations, most of your S corporations, are active businesses, they’re not investment vehicles. If you’re not actively involved in that corporation like you’re the money partner in the S corporation and your other shareholder in the S corporation is the active person, for you that would then be passive.
All rental activities and the oil and gas people had a strong enough lobby to keep their work out of that. If you happen to have an oil and gas investment, it’s generally not going to be considered passive but real estate is. Carries over.
Real estate exception. The real estate exception for active participation in the real estate if you have adjusted gross income, that’s the bottom number on Page 1 of your 1040. The bottom number on Page 1 of your 1040 is your adjusted gross income. Without considering your real estate in that number, if that number exceeds $150,000 you can forget about this, it doesn’t apply to you. If it’s $100,000 or less, you can take up to $25,000 of your passive rental losses, your passive losses against your ordinary income, it’s an exception to the rule. $25,000 if the losses are that high, up to $25,000 you can take against your ordinary income, just flows straight through very nice. Again, if your adjusted gross is between $100,000 and $150,000, that $25,000 goes down to zero. It’s just a proration over that income level.
All right. A lot of confusion about this. This is the Medicare tax that Bob had alluded to. 3.8% additional tax and it’s a little tricky in terms of who it applies to and when it applies. It’s focused on unearned income.
Okay, what does that? Obviously, your wages and salary income are not part of that.
The primary items that are included in this additional tax, all your interest income, all of your interest income, that includes interest income that you would receive from a partnership or a corporation. Not a C-corporation, but if you have an S-corporation that’s flowing interest through to you. Also, all of your dividend income, any income from annuities, royalties, all of your passive income and includes your capital gains and commodity trading.
The inclusion of capital gains is a big one on here. Bob alluded to this and his point was an excellent one, if you have a large capital gain that’s going to cause you to have your adjusted gross go over the $200,000 or $250,000 limit that you’re looking at to have to pay the additional tax, you might want to consider an installment sale and stretching that gain out because this is a year, by year, by year, by year calculation.
You look at a year in a bucket all by itself and you will either be subject to the tax or you won’t in that particular year. You may bounce in and out of this one. Who is subject? Single individuals adjusted gross over $200,000, married couples filing jointly adjusted gross over $250,000 and this is one that’s not talked about much.
If you have a situation, let’s say where you have a relative who’s recently passed or for whatever reason you have investments in a trust, this is not a living trust, or a family trust or a trust that’s ignored for tax purposes.
This is a real trust that’s filing a trust tax return on a 1041. If you have a trust for a deceased relative and they’re filing a tax return, this 3.8% additional tax kicks in when the net income from that trust that was not distributed to beneficiaries goes over $12,150. Well, come on. That’s like right away.
This is just a word of caution if you happen to have a situation where you’re involved with a trust and if you have a relative that’s passed away recently or when that should happen, be aware. Because with many of these trusts, the trustee will just hold on to all the income until they get near the end and then distribute.
It’s quite common to have income in the earlier years where the tax is paid by the trust, not the beneficiaries. You might just suggest, “Hey, distributed amount out to the beneficiaries to get rid of the trust tax if trust tax rates are higher than individual tax rates.” Like I say if you get over $12,150, you’re going to add another 3.8% to that. If you distribute that money out of the trust before the end of the year, then the beneficiaries pay the tax at their own rates and they got the cash to pay the tax. So everybody wins except for the government.
Capital gains and losses. Briefly. Capital gain treatment. Property are held over a year obviously, you’ve got long-term capital gains. Again, you may be subject to the Medicare tax, you have to be careful watching for that. Know whether you’re in the 15% or 20% tax rate for that. Capital losses, very important with capital losses. I think most of you are probably aware of this, but you’re limited to $3,000 a year in your deduction of capital losses. Again, like with a passive income loss rules, the very first thing you do is net all of your current and your capital gains and losses together. Net them all together.
Then, if you have a capital loss after all that netting is done, you get to take $3,000 of that against your ordinary income. I’ve had clients with capital gains large enough that they figured they’re not going to live long enough to use up capital losses. They’re trying to do everything they can to generate capital gains every year on their tax return because it’s basically tax sheltered. You need to know where you are with your capital losses and just be sensitive to it because it’s affecting what’s happening to your return.
Internal Revenue Code section 1231. This is sweet. All right. Most tax law goes the way that the capital gains rules work, which is if you got income we’re going to get it and if you got losses, we’re going to put some limitations on it. Section 1231 says, “If you’ve got rental property, you got commercial property, you got real estate property and you sell it and you sell it at a gain, you’re going to get capital gains.”
You get a tax benefit on the upside when you sell that real estate. Pretty good. That’s nice. You got a big portfolio, you’re not going to win a hundred percent of everything on everything. Everyone’s money get lost. What happens if you dump one or get rid of one and you end up with a loss? Big smiles all around. Section 1231 says, “You can take an ordinary loss on that real estate loss.”
This is a big deal. It will allow you the flexibility to get out of the bad property without having to stress over the fact that, “I’m going to be generating a capital loss and I can only use $3,000. It’s going to be there forever.” No. Make sure you check with your accountant, make sure you’re qualified. In general, if you have a 1231 loss, you take it directly against that year’s ordinary income. It’s sweet. I’ve seen taxpayers have very favorable results on their taxes in a particular year because of the benefits of 1231.