The Loss Limitation Real Estate Investors get to Skip

The At-Risk Gate

When you are game planning your own tax strategy, there is nothing worse than getting to tax time and getting hit with a surprise.

“What do you mean I can’t take those losses?” “What happened to my tax losses?” “I was promised when I bought the investment that I’d get tons of taxes back on this”

‘I hit 100 hours just like Claude told me to; this doesn’t make sense.’

And normally, these are fair questions to ask. Getting blind sided on missed savings ruins your capital stack, hurts your financial planning, and honestly gums up the entire process.

Here’s one thought process that most don’t think about enough:

The At-Risk rules of § 465. While this generally doesn’t hit RE investors as hard, it can if you look at alternative investments or don’t have a guarantee on seller financing.

Here’s how we can avoid this at tax time.

There’s a basic framework to follow for tax losses: Tax basis → At-Risk Basis → Passive activity rules → Excess Business Loss limitations.

These are all separate issues, and you can read all about 469, but we’ll cover what a basis is, and then what an ’ at-risk ’ basis is.

What Counts as “At-Risk”

So, what is ‘basis’? Basis is essentially what you purchase the property for, with cash and also debt. So if you put $100,000 down and get a $900,000 loan, your tax basis is $1,000,000 (100k+900k).

This is where you start your depreciation calculations and calculate any gain or loss when you sell the property down the road (see § 1001, § 1011 & § 1012).

Debt was officially made part of the basis in Crane V Commissioner (famously, in a footnote) and made standard the idea that debt, including non-recourse debt, was in your basis.

So that’s the short version of standard tax basis. You look first to see if you can take deductions there (more applicable with entity investments), and you move on. There are also two kinds of debt in the tax code (and the real world).

Recourse Debt and Non-Recourse Debt

There is recourse debt and non-recourse debt.

Recourse debt in the business world can be summed up as meaning ‘the lender can come to your house and break your door down if you decide not to pay’.

Yes, there are always legal battles and such, but that’s the easiest way to break it down (pun intended).

Nonrecourse debt is debt where the bank can’t take your home, but they will bang on your door until they just decide to take the asset.

Why does that matter? After the ‘tax basis test’, we now must analyze § 465(b)(1), which states that deductible losses are only allowed UP to at-risk amounts.

So, what does that mean? That means cash contributed/paid (down payment) and any part of the loan that is considered to be ‘recourse’. So now you ask, why does this matter?

Let’s say you purchase a piece of machinery, specifically, a bulldozer. Now imagine you put $50,000 and borrow $150,000. That $150,000 is considered non-recourse debt.

This means, if you use depreciation, and bonus depreciation at that, you CAN depreciate the full amount. But, you are stuck with the limitation of the at-risk rules. This results in you taking $200,000 of depreciation, but it’s now ‘trapped’ by at-risk, only allowing $50,000 as a real deduction.

You still have access to it (as you pay the loan down, the losses will be released). But it’s something that has to be tracked and considered. In the business world, personal guarantees are fairly common, which fixes this issue. (See § 465(a))

The reporting of the at-risk basis goes on Form 6198.

The Real Estate Carve-Out

Real Estate, of course, gets a great exception, Qualified nonrecourse financing (QNRF) (§465(b)(6)).

Why is real estate the exception? Well, because real estate lobbies are pretty powerful. In reality, to promote real estate investment, it makes sense to allow this exception, as non-recourse financing is the standard method of buying real estate.

QNRF counts toward at-risk even though nobody’s personally liable.

There are four tests to qualify for the exception, however:

1. Is this real-property activity?
2. Was the debt borrowed from a “qualified person” (or government)
3. There is no personal liability attached or embedded in the debt where someone must repay (which would make it recourse)
4. Partner’s share follows the share of liabilities, and it cannot be convertible.

So, what is a real-property activity? It is essentially the holding of property for living accommodations. This means hotels or any properties that provide substantial services will no longer qualify for this exception.

Also, what is a qualified person? A qualified person is a bank, savings & loan, credit union, or other financial institution. Other qualified persons are insurance companies, government entities, or some pension/retirement plans as well.

Also, it cannot be any ‘related’ (think up, down, left, right, ancestry, parents, siblings, kids, uncles and cousins not included) who is making the loan as well.

The exceptions are relatively well thought through, and have been around for a long, long time. Promoters generally forget, or try to find workarounds to avoid this, but it’s relatively difficult to do so.

Where QNRF Breaks (The Traps)

QRNF used to be relatively common; however, current market conditions foster creativity, which creates breaks in other places.

The market is seeing a lot of seller financing deals, and unless there is a personal guarantee behind it, this debt no longer meets the QRNF standards. This is commonly missed by those in the tax world, and is only a few years old issue that has grown to be a bit more commonplace.

If the party is also related under § 267, this breaks the qualification (see earlier note on this).

The biggest issue is the number of substantial services being provided. This is a large deal-breaker ultimately. Most debt will be non-recourse (especially for a single-family home converted into an STR that provides a large number of services).

Now, it’s also worth remembering that most STRs do not provide substantial services across the board. But it’s something to consider and be aware of.

Seller financing/elated-party or promoter loans failing the “qualified person” test; convertible debt; property securing the loan that isn’t the real estate; personal guarantees flipping “nonrecourse” to recourse — and how a guarantee can help or hurt.

Conclusion

Most real estate does not need to worry about the at-risk test and limitations. But it is something that should be considered so you don’t get his with a surprise at tax time.

At risk is not as difficult to overcome as the passive loss rules are for real estate, but it is something that should be identified on the front end.

Being blind sided on tax day is not a situation anyone wants to be in.

If unexpected tax loss limitations are the last thing you want, it may be time to work with a tax strategist. Schedule a free discovery call today.