2024 – Year End Tax Strategies & Tips Before the Year Is Over!

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Hi everyone, Stephen Morris here with AdviseRE. Today we’re going to focus on a very narrow topic regarding how you can take losses and what hurdles you must overcome to claim those losses, specifically around real estate transactions. As you know, here at AdviseRE, we’re huge proponents of harvesting tax losses in order to offset our taxable income.

The three hurdles for being able to take a loss are as follows. The first one is that you need to have basis. Basis is a foundational concept in the tax code, and without it, you’re unable to take any losses whatsoever. The second hurdle is that this basis must be “at risk.” We’ll dive into the specifics of what “at risk” means under the code in just a moment. Finally, once you have basis and it’s at risk, you must then pass the passive activity rule hurdle, which is the final step in allowing the deduction. This process ultimately brings our taxable income down and makes us very happy taxpayers with a much lower tax liability.

With that, let’s begin our discussion about basis. As I mentioned, basis is a foundational concept in the tax code. In the context of real estate, basis is primarily composed of two things:

1. The cash you invest in the real property.
2. The amount of money you borrow toward buying that property.

Remember, basis will only be included to the extent that the money spent is tied to some sort of acquisition or improvement activity. Therefore, refinances subsequent to your purchase, which are not invested in that particular real estate activity, will not add to that property’s basis.

For example, let’s say we bought a property—like an office building—for $1 million three years ago, using $500,000 of cash and $500,000 of loan proceeds to complete our acquisition for $1 million of purchase basis. Subsequently, the market becomes red hot, and the property is worth $2 million. A bank approaches us, offering an additional $800,000 of debt proceeds to invest in other real estate activities.

I’m in favor of this because I’m always about real estate and investing, and I’d love to lever my property to acquire more properties. However, that additional $800,000 I borrow would not be used toward the basis of this real estate asset. My basis remains at $1 million minus any depreciation I’ve taken. Meanwhile, that $800,000 I deploy elsewhere might count toward basis on another asset. Fundamentally, what this means is that I’m limited to a million dollars of potential losses. Once I’ve exhausted my $1 million of basis, there’s no more opportunity for me to take deductions on that particular real estate asset.

Now that we’ve covered basis, let’s talk about the second hurdle: at-risk basis. Back in the 1980s, Congress was not pleased with the outcome I’m about to describe.

For example, consider a taxpayer who acquired an interest in a partnership. In that partnership, they invested $1 in cash, but under partnership tax rules were allocated $10 of additional debt basis, which was non-recourse to the taxpayer. In other words, if that company were to go bankrupt, the taxpayer would not be on the hook to pay the lender. In this scenario, assume the $10 plus the $1, for a total of $11, were spent on various business expenses, and under the partnership tax rules, those losses would then be allocated to the taxpayer.

Keep in mind, he only put in $1, yet he received an $11 deduction. Under the current tax code, that’s a 37% tax benefit, or about $4 of tax savings for a $1 investment. Congress was not pleased with this outcome, so they passed Code Section 465, introducing the concept of at-risk basis to the tax rules. Code Section 465 specifically calls out which activities or investments will add to your basis and be considered at risk. These include cash invested (clearly at risk), recourse debt (debt you personally guarantee), and qualified non-recourse debt (a non-recourse loan secured by real estate under the code). Conspicuously not included in at-risk basis is plain old-fashioned non-recourse debt. It’s uncommon, but if a lender provides a non-recourse loan to an entity with no security guarantee—and no one signs their name on the dotted line—then that debt would not be included in the taxpayer’s basis and would be considered not at risk.

How does this all relate to real estate? Specifically, there’s one area I want you to focus on as a key takeaway, because the at-risk rules are extremely technical.

Let’s consider an example. You and I form a partnership and purchase a $1 million piece of property, assuming it is 100% financed and that the entire property’s basis is depreciable. These assumptions aren’t normal, but for simplicity, we’ll go with them. We then seek $1 million in acquisition financing to buy the property, taking the title under our partnership. Under partnership tax rules, half of that loan is allocated to me, half is allocated to you, leaving each of us with $500,000 of basis in the property. We then run a cost segregation study and, miraculously, $1 million is immediately deductible as a result of accelerating depreciation.

Now let’s fast forward a few years. The property has appreciated in value, our basis is zero, and it’s worth $2 million. Fast forward a bit more, and we have a basis of zero, fully depreciating everything on our tax return. Simultaneously, the property’s value has climbed to $2 million. Another lender approaches, offering a $2 million loan against the property at a lower interest rate. Perhaps I’m not interested in the loan details because I’m abroad enjoying myself, but you find the opportunity fantastic—more loan proceeds at a lower cost. You decide to sign the guarantee on the loan, because no bank will lower the interest rate without someone signing on the dotted line.

In this scenario, once the transaction is done and you become the sole guarantor, the way at-risk and partnership tax rules work is that all recourse debt is allocated solely to the guarantor. Since I refused to sign while partying in Ibiza, and you took on the responsibility, you end up with all $2 million of that loan allocated to you, giving me something called a negative basis. Under both at-risk and basis rules, negative basis is impossible. To get back up to zero basis, we have to consider something called recapture. That means all the depreciation deductions I took over those previous years would be added back to my taxable income in the year of refinance. This outcome can be devastating, especially if you’re syndicating real estate deals and considering refinancing the property after fulfilling your initial investment goals. The key takeaway: before signing those loan documents, contact us. We’ll ensure there is no significant tax impact that would anger your investors.

The final hurdle is the passive activity rules. Similarly, in the 1980s, Congress disliked that people were using investment vehicles to generate tax losses to reduce their overall taxable income. Tax rates were much higher pre-1980s, especially under the Internal Revenue Code of 1986, so Congress passed Code Section 469 to limit taxpayers’ ability to use passive investment losses to offset other income. All real estate is deemed passive under the Code, and there’s no way to group real estate activities with non-real estate ones. For instance, if you own a bakery and also own property, you can’t combine the two activities so that depreciation losses from the property offset your bakery income.

However, as we’ve often mentioned in this channel and our blogs, there’s the real estate professional exception under Code Section 469(c)(7). This allows someone who puts in over 750 hours per year in real estate trades or businesses—and spends more than half of their total working time in those trades or businesses—to offset other income with real estate losses. Note, as we always say regarding California, that state doesn’t acknowledge the real estate professional concept, meaning you could have a negative taxable income for federal purposes but still owe a hefty tax bill in California.

In short, once you clear these three hurdles—having basis, having at-risk basis, and qualifying as a real estate professional under the Code—you can harvest real estate losses, reduce your taxable income, and significantly lower your tax bill. This frees up capital to reinvest in new opportunities. If you’d like more guidance on how this works or specific examples of how it might apply to your real estate investments, reach out to us. We’re more than happy to discuss what it takes to achieve these benefits.

Thanks so much for watching, and we look forward to seeing you in our next video