How to use passive losses and passive income generators as a tax strategy

Back in the 1980s, taxpayers with a high tax rate would invest into real estate and other similar investment vehicles and end up with large upfront losses, such as depreciation, that offset their other ordinary income. Many thought this type of sheltering maneuver was unfair, says Tony Constantine, tax partner at Ciuni & Panichi Inc.

To slow this tax sheltering down, Congress created a framework of rules and classifications of activities for passive and non-passive income. Taxpayers can now only can offset passive losses again passive income. And if there is no passive income, it carries forward.

“That’s where a passive income generator comes in because it can be a tough pill to swallow when you’ve got a $20,000 loss on your tax return that you cannot utilize,” Constantine says. “If you have passive activity losses carrying forward, you can invest in something and accelerate the use of the losses that would be available at some point in the future.”

Smart Business spoke with Constantine about pairing passive losses with passive income generators.

How do taxpayers acquire passive losses?

Passive losses are ordinary losses generated by a passive activity. A passive activity is a business that a taxpayer is not involved in such as a silent partner in a business or owning real estate. Just because an activity has a passive loss doesn’t mean it’s a bad investment. It could be a rental property that has significant depreciation in any one year, which generates a loss, but is still cash flowing.

There is a framework of rules governing whether a taxpayer is a passive investor. However, it’s not cut and dry when looking at multiple activities. If you’ve invested in, say, five different real estate properties, it goes property by property and there’s an aggregation election you can make, if you meet certain hour requirements.

It’s also important to note that looking at financial statements or refinancing a property are considered investor activities. They don’t count as spending time on an activity for non-passive purposes.

How does someone know if they have passive losses on their tax return?

If you cannot remember if you’re carrying passive losses forward, check to see if Form 8582 is part of your tax return package. This form details out all passive loss carryforwards.

If your underutilized losses are building up, you can look at certain investments that might generate some income of a passive nature to offset that.

What investments can provide passive income generators?

A passive income generator may not fit everybody and you never want to let the tax tail wag the dog, but it’s beneficial to consider the investment tools that are out there to set your affairs up in the most tax-efficient manner.

Passive income generators can be an investment that’s marketed as a passive income generator, such as real estate or private equity funds that are structured in such a way that they’re going to throw off income. They may be more mature properties that don’t have much depreciation and little interest deduction, so they’re in the cash flow stage. You invest in a property that’s going to appreciate in value and throw off some income and corresponding cash, but you shelter it with your passive losses.

You never want to make an investment just to offset passive losses, because every investment has its risk. If something is supposed to be a passive income generator, it could be a loss if something goes wrong. But if you’ve looked the risks and you want to make an investment, making one in something that is going to generate some passive income to offset your passive losses just makes sense. You’re going to save yourself tax on that, either that year or in future years by offsetting the two.

Insights Accounting is brought to you by Ciuni & Panichi Inc.