Taxes and passive real estate: what to ask your CPA

Tax treatment is one of the reasons people look at real estate, and also one of the most commonly oversimplified. The goal here is not to tell you what will happen to your taxes. It is to help you ask better questions.

What you will probably receive: a K-1

Investors in partnerships and LLCs taxed as partnerships typically receive a Schedule K-1 each year, reporting their share of income, losses and other items. K-1s often arrive later than other tax forms, so some investors file extensions. Ask your CPA how that fits into your usual filing routine.

Depreciation, in plain terms

Tax rules generally allow the cost of certain real estate to be deducted gradually over time as depreciation, even when the property is not actually losing value. This is a non-cash deduction, which means a deal can show a tax loss on paper while distributing cash. Methods that speed up depreciation exist, and the rules around them have changed in recent years. Ask your CPA what applies now.

Passive losses and physician income

Here is where many physicians are surprised. Under the passive activity rules, losses from passive investments generally can only be used against passive income, not against wages or practice income. There are exceptions, but they come with conditions, and higher-income taxpayers often do not qualify for the more commonly discussed ones.

Losses you cannot use in a given year may be carried forward and used against future passive income or when the investment is sold. Ask your CPA how the passive activity rules apply to you specifically.

What can happen at a sale

Depreciation taken over the years may be partially taxed again when a property is sold, a concept often called depreciation recapture. Sale proceeds may also include capital gains. Ask for a walkthrough of how a sale could be taxed in your situation.

Other items worth raising

• State filings. Investing in a property in another state can create filing obligations there.
• Retirement accounts. Investing through an IRA or similar account has its own rules, including how borrowing inside the investment may be treated.
• Estimated taxes. Whether distributions or allocated income change your quarterly payments.
• Record keeping. What to keep, and for how long.

A short list for your CPA meeting

• How would a K-1 from a real estate partnership change my filing process?
• Would the passive activity rules limit my ability to use losses?
• How would depreciation and a later sale affect my taxes over the full life of the investment?
• Do I have state filing obligations if the property is outside my state?
• Is it wise to hold this investment in my name, a trust or a retirement account?