The Laurex Process: Strategy Clarification
Passive Income Tax Affects
By Ray Smith

Question: I am a relatively new investor with two four-plexes. I was told that if I and my spouse earned more than $150,000 a year in joint income, we could not take losses from our real estate on our taxes. Is this true? If so, should I form a limited-liability corporation and put the property into the LLC? Is there a franchise tax in Texas for LLCs? How do I move the properties from my name into the LLC name, considering the mortgage and title?

Answer: Regarding your first question about losses, hang tight because it's complicated. There are many Internal Revenue Service rules and exceptions that affect the loss. An individual taxpayer who owns rental real estate, even if he or she actively participates in the management of these properties, is typically subject to passive-activity rules. Passive-activity rules restrict taking losses from rental real estate. Passive-activity losses are generally not deductible against other types of income such as wages, interest, dividends or most capital gains.

Steven E. Miller, a certified public accountant in Plano, Texas, points out that the average rental real-estate investor often qualifies for one particular exception to the passive-activity rules. This exception allows individuals to deduct up to $25,000 ($12,500 if married but filing separate tax returns) of losses from real-estate rental activities against all types of income (passive, active and portfolio). However, the $25,000 is reduced by 50% of the taxpayer's adjusted gross income -- the number at the bottom of page 1 of your 1040 federal income-tax form -- that exceeds $100,000 ($50,000 if married but filing separate returns).

By the time you reach $150,000 ($75,000 if married but filing separate returns) in adjusted gross income, there is no deduction remaining, says Mr. Miller. It has been fully phased out and any un-allowed losses are suspended and carried to future years. These losses may be deducted in future years if your adjusted gross income drops below the limits or you fully dispose of the rental activity.

You may qualify to fully deduct the rental losses under another, less restrictive exception. If the taxpayer qualifies as a "real-estate professional," then the losses from rental real estate aren't treated as passive and aren't subject to the passive restrictions at all.

To qualify for this exception, the taxpayer must pass two tests: More than 50% of the personal services performed by the taxpayer must be in real property trades or businesses, and the taxpayer must work more than 750 hours during the year -- about 15 hours a week -- in these same real-estate businesses. Though 15 hours a week may not seem like much, the majority of the taxpayer's efforts must be towards real-estate activities. "That is often the tougher hurdle to jump," says Mr. Miller.

As for your other questions, Mr. Miller says that moving the rental properties into an LLC or other business entity doesn't allow you to bypass the passive-activity rules. What's more, the $25,000 deduction for being an "active" owner -- the person who approves new tenants, repairs and capital expenditures -- applies to individuals only.

Additionally, LLCs in Texas must file an annual state franchise tax return whether they owe tax or not.

And if you still want to move the properties from your name into the LLC, consult a real-estate attorney for details on transferring the mortgage and title.

Article Provided by:

Ray Smith
Wall Street Journal
Dec 5, 2003