Part Three of Financing a Second Property: Passive Activity Loss

The world of tax deductions for small businesses and second properties is a labyrinth of schedule E vs. schedule C forms, allowable deductions, exceptions and special circumstances. I thought I knew many of the rules because, as a freelancer, I had written a 17,000 word series of video scripts designed to train Realtors in selling vacation homes. But it truly is a complex and overwhelming area of the tax code, and I am learning new things all the time.

Case in Point: The Passive Activity Loss Exception

One of the things I didn’t realize when I purchased the Anchorage and Cabin is I would be able to take advantage of a special tax deduction designed for individuals who experience passive activity loss (PAL) with an investment property. Provided that you are “materially involved” in the management of the property — that is, you take an active role rather than letting a management company handle the details — and provided that you have at least a 10 percent ownership interest in the property, the IRS makes an exception to their general rule that rental losses are passive and can only be offset against other passive income. The upshot is you get to claim a tax deduction up to $25,000 against all income gains, including ordinary income, each year you meet the qualifications.

Okay, this sounds awesome — but of course it’s not that simple. Nothing in the world of small business taxation is even remotely simple; exemptions and exceptions volley back and forth schizophrenically, sometimes in the same document. The problem here? This deduction gets phased out once your modified adjusted gross income (line 38 on your 1040) rises above $100,000 a year, and if your MAGI is over $150,000, you can’t take the deduction at all. In other words, divorcées who don’t usually make squat but decide to cash out their retirement accounts to purchase a historical Maine homestead don’t get to deduct a goddamned thing for that tax year. Goddamn it.

The IRS does allow you to carry the deduction forward into subsequent tax years — at least that’s what I hear from my accountant. What I’m not entirely sure about is if I’ll be able to take the deduction against ordinary income or just against my passive rental losses. If the former, it seems likely that I will be able to recoup about a third of the taxes I’m paying in 2015, though I may have to phase that out over several years.

Beyond that, there are a number of variables:

• Is it better to manage the property myself or have a company take care of these details for a fee?
• Would I make more money renting out both houses and using a service or occupying the Cabin and taking a hand’s on approach to renting the Anchorage during the summer season?
• Should I run the Anchorage as a small business venture, or would it be more advantageous simply to rely on the passive seasonal rental income?

Fortunately, these are questions I don’t have to answer right away.

Nest Egg or Cash Flow

I want to finish this post by touching on a particularly insightful bit of information that one of my freelance clients shared with me. I told him what I was about to do, and rather than try and talk me out of it, he pointed out that the rental revenues I’d have coming in would be equal to the interest on a large nest egg.

I’d never thought about it that way, but it’s true. By the time I retire, annual rental income from the Anchorage will be equal to 4 percent interest on a $500,000 capital sum, and unlike money placed in a safe investment, like a CD, this income stream is tied to inflation.

One of my favorite moments in cinematic history occurs in Albert Brooks’s 1985 comedy, Lost in America, right after the character played by Julie Hagerty gambles away all of the money she and her husband, played by Brooks himself, were going to use to support themselves in their quest to touch Indians and sleep beneath the stars.

“The egg is a protector, like a god,” an irate Brooks rants at her, “And we sit under the nest egg, and we are protected by it. Without it, no protection.”

The Nest Egg Principal is what most of us emulate as we move toward retirement. The goal is to accumulate a large sum money so that we have enough interest income to supplement what we will receive in the way of social security and pension. Without the “nest egg,” we’ll barely have enough to scrape by.

I’m not knocking this principle. But there’s something to be said for taking a gamble as well.