What are passive activity rules for your rental properties and do we care about them?
By definition your rental activity is considered passive unless you meet certain tests.
I will not get into details about the tests as this is something for you to discuss with your tax advisor. But generally, if you manage everyday activity of your rental property it will NOT be considered passive.
What if I outsource everything to the management company? Or what if my partner takes care of most issues and I am just reaping the profits. If you hire someone to deal with everyday activities and make no material decisions on regular basis, then it might be considered passive investment.
What does this passive thing actually mean?
Passive investments are not necessarily a bad thing. However, if you are generating loss then this loss is considered passive and it is only deductible against Passive income.
If you have other passive income, such as another property that is generating huge income or you are limited partner in another venture you have nothing to worry about, and your loss will be deductible up to the income from other passive investments. If you do not have any other passive income, then the loss gets suspended to future years. You do not lose your losses, you just have to wait until you get more profitable.
What if it is time to sell and get out?
Then you are in luck, you passive losses will be automatically allowed. Selling the property involves another layer of complicated tax laws that we will get to later.
But to summarize this section, I would like to go over a simple example.
Peter runs a small Airbnb. He generated $50,000 revenue and has $40,000 of expenses excluding depreciation of his home. The depreciation calculated for the year is $17,000.
Income - $50,000
Expenses - $40,000
Depreciation - $17,000
Net loss - ($7,000)
If Peter does not manage his Airbnb and lets his cousin who leaves nearby take care of the guests and the maintenance of the property, Peter might be in the situation where ($7000) loss is passive. Luckily, Peter is a smart investor. He likes to diversify his assets. He also invests in stocks and ETFs. He generated $5,000 profit from sales and occasional dividends. And he also invested in a small partnership that his coworker is running. He makes no decisions in his coworkers business and the business made money this year. Peter's share of the profit is $3,000.
How much of the ($7,000) loss can Peter deduct this year?
Well, the stocks are not considered passive investment and the loss is not deductible against $5,000 gains. On the other hand, the partnership with coworker sounds like a passive investment and $3,000 will be offset against the profit.
To sum up, out of ($7,000) loss we will be able write off $3,000 against partnership profits.
$4,000 loss ($7k - $3k) will carryforward to next year. And we are only left with $5,000 gains on the stock market.
Are you still with me? If you are and want to know more about how taxes affect your Airbnb profits, stay tuned. This is only a part 1 of mini tax series.
What are other complicated tax issues that you would like to know more about? Leave a comment below. All reasonable offers will be accepted.