Part 9 in an annual 12-part series on realty tax tips.
In 1993, the Congress and President Clinton realized the 1986 Tax Reform Act was too harsh on real estate investors.
Since the 1986 law discouraged realty investment and caused declining rental property values, it was a major cause of the multibillion-dollar bank and S&L crisis because realty investors had few tax incentives to invest.
But the 1993 Clinton Tax Increase Law will actually decrease taxes, beginning in 1994, for thousands of realty investors who spend significant time supervising their properties.
Real estate investors with annual adjusted gross income (AGI) below $100,000 can currently shelter up to $25,000 of their ordinary income with passive income losses from their realty investments if they materially participate in managing their property and own at least a 10 percent interest.
But limited partners are not eligible since they do not actively manage their property.
However, most passive losses from property investments, such as apartments, commercial buildings and rental houses, are paper losses since the depreciation expense for estimated wear, tear and
obsolescence is a non-cash tax de-
duction. Currently, residential rentals must be depreciated straight-line over 27.5 years and commercial buildings acquired after May 12, 1993, over 39 years (31.5 years before that date).
Real estate investors with AGI between $100,000 and $150,000 lose their passive loss tax deductions at the rate of $1 for each $2 of income more than $100,000. Investors earning more than $150,000 AGI cannot deduct any passive realty losses against their ordinary income, except for losses from low income housing.
The tax result was discouraging wealthy taxpayers from investing in rental property, thus depressing market values, so Congress changed the law for the 1994 tax year.
Two tests for 1993 tax year passive loss tax deductions:
If you earned less than $100,000 AGI in 1993, you can deduct up to $25,000 of real estate passive losses from your property against ordinary income, such as wages, interest and dividends, if you pass the following tests:
You must materially participate in managing the property. The 1986 Tax Act automatically called all real estate rental income "passive income" no matter how much time the owner spent managing the property. To be able to deduct up to $25,000 of annual losses from property operations against ordinary income for 1993, the owner is required to "materially participate" by making at least the major managerial decisions.
You must own more than 10 percent of the property. The 1986 Tax Act required any owner who materially participated in property management to own more than 10 percent of the property. Joint owners of less than 10 percent interest, such as limited partners, automatically are disqualified for lacking material participation.
Effective for the 1994 tax year, rental property owners can avoid these two 1986 Tax Act passive activity tests above if they spend at least 750 hours per year, or 50 percent of their working time, in realty management, development, construction, acquisition, conversion, leasing, or brokerage. When a married couple owns a rental property, only one spouse need qualify for this liberal new tax break.
Suspended passive losses can be used to shelter resale profits. One redeeming benefit of the 1986 Tax Act for realty investors is any unused passive losses which a taxpayer cannot deduct against ordinary income can be saved or "suspended" for use in future tax years or to offset property resale profits.
IRS Notice 88-94 clarifies passive losses from an investor's rental properties can be taken as a whole to offset profits from sales of these properties. Some tax advisers thought losses and gains could only be offset on a property by property basis, thus creating a bookkeeping nightmare.
Strategies for profiting from real estate investments: Smart investors are still acquiring rental real estate. Some are investing in low income housing, with its generous tax credits but its disadvantage of a long holding period.
Other investors are buying income property, but insisting it produce a positive cash flow and offer profit potential from appreciating market value. Still others acquire run-down fixer-upper properties to force their market value up by making profitable improvements. This technique is called "forced inflation."
The new 1994 tax law changes should stimulate new investment property acquisitions by investors who spend considerable time involved with real estate.
Investors should consult their tax advisers to maximize their tax benefits from this important tax law change.
Next: The pros and cons of home equity sharing.
Robert J. Bruss is a nationally syndicated columnist on real estate.