Make PALs with your PIGs: Discover the Potential Benefits of Passive Income Generators

Topics: Capital Markets/Commercial Real Estate, Passive Income Generators

Investors that have multiple passive real estate investments in other passive programs with expenses that exceed cash flow will generate passive activity losses. In many cases, managing taxable income, tax rate, and effective amount of taxes being paid means identifying specific strategies that can minimize taxable income.

What is Passive Investing?

One form of passive investing is when an investor chooses to outsource their real estate investments to a manager and pays them a portion of the profits for their services. Managers pool money from numerous investors to buy more extensive or whole portfolios of properties and run all day-to-day operations for these assets. They acquire the properties, execute the business plans and report to investors. In many cases, individuals are still direct owners of the underlying properties, receive all tax benefits and any income generated by the property or properties. This is an example of a passive income generator (PIG).

What are PALs?

For example, cash investors passive activity losses (PALs), will generally arise in a year if the sum of (a) deductible loan payments (e.g., payments of interest on loans) and (b) any depreciation to which an investor is entitled, exceeds the income generated by the investment in the year.

A way to get a tax benefit from those losses, prior to the disposition of the passive real estate asset, is to have passive income. Passive losses are not deductible against any kind of income except passive income. Given the complex nature of the PIG/PAL strategy and the rules regarding the deductibility of passive losses (whether from an investment in an interest, or from other passive activity that could potentially be used to offset income), it is imperative to consult accounting and tax professionals to determine if this investment approach is appropriate. Each investor’s tax circumstances are unique, and this information does not constitute tax advice.

Hypothetical Example*

An investor has $100,000 in passive activity losses. The investor is looking to carry forward losses over a 10-year period and considering an investment which produces 4% in cash flow over that 10-year period. This investor will need to determine the amount of money necessary to invest in order to produce $10,000 of passive income, offsetting his passive losses.

Formula

  • $100,000 passive activity losses divided by 10 years (carry-forward period)
  • Looking to offset $10,000 in passive activity losses per year
  • $10,000 passive income / 4% (hypothetical cash flow) = $250,000.00
  • Investment of $250,000.00 equals $10,000 of tax-free income per year assuming a continuing 4% cash flow

In this example, at year end, the investor will receive a Substitute 1099 statement of income and expenses to use when completing his IRS Schedule E. The investor will not receive a Schedule K-

Both investors and financial professional with passive real estate investments should take note of how passive income may allow the conversion of passive losses into a significant tax advantage.

*This hypothetical calculation of passive activity losses model and any accompanying communications have been prepared for informational purposes only, and are not intended, and should not be construed, as tax, accounting or legal advice to any potential investor. All prospective investors are strongly encouraged to consult with and rely on their own tax, legal, accounting, financial or other professionals.

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