Tax Shelters & Passive Activity Loss: Definition & Rules

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson, you will learn about the tax benefits of real estate. We will cover the definitions of tax shelters and passive activity losses. Understanding the rules of these topics can help a real estate investor become more profitable.

Tax Shelter Definition

Marcus moved to a new city and is renting out his old house. He's happy with the money he is making from the house, and the tenants are great. When tax time came, he started thinking about taxes from his new side business of being a landlord. How can he legally avoid paying taxes so he can use more of that rental income for his own wants and needs? A tax shelter is a legal method of reducing a taxpayer's taxable income. The less taxable income an investor has, the less they pay in taxes. Sounds simple enough, but how does this work in real estate?

Real estate is a business. Investors collect income in the form of rents or capital gains when the property is sold. While the investor owns the property, they pay mortgage interest, property taxes, insurance, and make repairs.

Depreciation Definition

Real estate also benefits from depreciation. Depreciation means that as the house gets older, it becomes worth less each year because parts get old. The depreciation deduction allows the investor to account for this loss as an expense for the first 27.5 years they own the property. The investor divides the building value by 27.5 years and gets to deduct that amount each year as depreciation. Picture a building worth $100,000 that sits on a property valued at $150,000. Every year the owner gets to deduct $3,636.36 (100,000 / 27.5). The deduction reduces the amount of taxable income on the investment that year.

After Marcus pays the mortgage, taxes, insurance, and repairs, he has $2,036.36 sitting in his bank account. Because of depreciation, Marcus can put on his taxes that he lost $1,600. He has a little over $2,000 in cash, but with the tax rules, he shows a paper loss. He can subtract that $1,600 from his regular job income. The result is Marcus not only legally avoids paying tax on his rental income but also saves some taxes that he would have paid from his regular job.

Step Up in Basis Rule Definition

Another form of tax shelter is the step up in basis rule. If Marcus sells the house, capital gain taxes are due on the increase in property value. Capital gain is the cost of the property plus improvements, minus any depreciation. If he's owned the house for many years, there could be a big tax bill. If Marcus has his son or a friend inherit the property when he dies, the basis resets to the value of the home on Marcus' death. A higher basis results in less taxes due when the heir sells the house. Owners keeping the home in the family for multiple generations to avoid paying capital gains taxes with each transfer to a heir.

1031 Exchange Definition

A 1031 exchange, named after the relevant section of the Internal Revenue Code, allows investors to sell one rental property and roll the money over into a new rental property without paying taxes. The investor delays paying taxes until the future sale of the new property. Combined with the step up in basis rule, an investor has options to delay paying capital gains tax. The rules of a 1031 exchange are complicated and the deal should be done with proper tax legal advice.

Passive Activity Loss Definition

The Internal Revenue Service (IRS) defines rental income as passive income activity. Likewise, a loss is considered a passive activity loss. The owner can take the amount they lost that year and deduct it from other sources of income on their annual tax return. As of 2015, the IRS permits passive investors to deduct a maximum of $25,000 per year if they file taxes as married filing jointly and have an income less than $100,000. The limits for single filers or married filing separately are $12,500 in passive losses and $50,000 in income.

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