As a physician, you may be approached with or have thoughts about opportunities to invest in real estate. There are a few ways to accomplish this, whether through joint ventures or owning your own residential or commercial real estate. It is important to not only identify whether these are sound investments through reviewing partnership agreements, sales documents, and calculations of expected rate of return but also understand how this affects your specific tax situation. Without an understanding of the tax effects of the investment, your goals for these types of investments may not be achieved.
Individuals often say they would like to invest in rental real estate properties in order to offset their W-2 wage income or even their interest and dividends. While that could be a great benefit, there are specific tax rules that must be considered. Passive activity loss (PAL) rules say that losses from passive activities, which are activities in which the taxpayer does not materially participate, cannot be deducted against nonpassive activity income like W-2 wages or interest and dividends. In addition, credits from passive activities cannot be used to reduce taxes on nonpassive activity income. Rental real estate is automatically classified as passive, but there are two important exceptions to this rule that may allow for more immediate tax benefits.
Active Participation Exception
First, if there is active participation, taxpayers can deduct rental real estate loss of $25,000 each year, and related credits can be allowed against nonpassive income. Active participation means an active involvement in the management decisions of the activities and at least 10 percent ownership. However, this exception phases out when adjusted gross income is between $100,000 and $150,000, so it generally may not be very beneficial for high-income earners.
Real Estate Professional Exception
Another exception to PAL rules applies to those who qualify as a real estate professional. This exception allows activities to not be treated as passive and enables the real estate professional to deduct all rental real estate losses. To qualify as a real estate professional, an individual must devote more than 750 hours toward real estate activities during the year. In addition, more than 50 percent of the overall services performed by the taxpayer during the year must be in real estate businesses with material participation. Material participation in an activity means involvement in the operations of the activity on a regular, continuous, and substantial basis, and there are seven different tests that can help establish material participation. To help meet the 750-hour requirement, an election is available to group activities. Under this election, the test can be met as a whole, rather than 750 hours for each separate rental activity. In general, solely being an investor in a joint venture without additional effort will not count toward these hours.
While a real estate professional does not have to work full time in real estate to qualify, the above tests mean that if you are a full-time physician, your hours in real estate would need to at least match the hours spent as a physician. For many, this could be extremely difficult to achieve. Keep in mind, if you are married, only one spouse must qualify as a real estate professional, so in many instances a nonworking spouse with an interest in real estate could have enough time to meet these tests and retain tax benefits.
If neither of these two exceptions apply to your situation, any rental real estate losses are not lost forever but are instead suspended and carried forward indefinitely. They can then eventually be used when there is other passive income or when the investment or real estate is sold.
Real estate investments should be viewed as an investment first, with the possibility of tax benefits. Real estate can provide diversification to a portfolio outside of normal stocks and bonds; however, there are risks to consider:
- Illiquidity – Real estate investments (direct or joint venture) are not easily sold and may not provide the value expected if sold quickly.
- Concentration – Real estate investments can be concentrated to one building, one city, or one state. This increases risk to the investors because an issue with a lease, zoning, or other items can affect the value of the real estate investment.
- Leverage – Real estate investment returns are increased by the use of leverage, by decreasing the amount of capital required to purchase property. However, if property values decline, investors may be required to invest additional cash to prevent foreclosure.
Each real estate purchase or joint venture investment should be reviewed in context of your specific tax situation. Reach out to your BKD Trusted Advisor™ or submit the Contact Us form below to see what could work best for you.
BKD Wealth Advisors, LLC is an SEC-registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks and should not be assumed that future performance of any investment or investment strategy or any non-investment related content will equal historical performance level(s), be suitable for your individual situation, or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.