In the world of real estate investing and tax planning, there is a saying worth remembering: “Pigs get fed, hogs get slaughtered.” When it comes to generating passive income and making the most of your passive losses, it pays to be the right kind of pig: a Passive Income Generator, or PIG.
Why Passive Income Matters
Passive income is the dream: money that shows up whether you are laboring or not. But in the tax world, the IRS has its own definition and a strict set of rules about what counts as passive activity and how losses can be used.
Back in 1986, the Reagan administration rewrote the rules with the Passive Activity Loss (PAL) limitations, designed to shut down abusive tax shelters. The result? The losses from passive investment activities can only be used to offset the income from other passive investment activities. That’s where PIGs come in.
The Problem: Trapped Losses
Real estate investors often find themselves with passive losses they cannot use, at least not immediately. Unless your income is under certain thresholds, or you qualify for one of the key exceptions, those losses just sit there.
Here are the three most common paths to unlock those losses:
The $25,000 Passive Loss Allowance: For rental property owners under certain income limits, this exception allows up to $25,000 of losses to be used against non-passive income.
Real Estate Professional Status (REPS): Qualifying as a real estate professional allows you to treat rental activities as non-passive, but the requirements are strict and well-documented.
Short-Term Rental (STR) Loophole: If your average rental stay is 7 days or less, and you materially participate, those rentals may be treated as non-passive, even without REPS status.
But what if none of these apply?
The Strategy: Find a PIG
Enter the Passive Income Generator (PIG), an investment that produces income without material participation. When the income is passive, it can unlock the value of your passive losses.
Think of a PIG as a tool in your wealth-building toolbox. It does not reduce your taxes on its own but when paired with existing passive losses, it can create meaningful tax savings and improved after-tax cash returns.
What Qualifies as a PIG?
Not all “hands-off” investments qualify as passive under IRS rules. Here are some examples that do qualify:
Real Estate Limited Partnerships (RELPs): You invest capital, receive distributions, and leave the operations to someone else.
Rental Properties (when the management is outsourced): If you are not materially involved, your income is passive.
Private Equity Real Estate Funds: These funds are designed for limited partner investors, providing income and potential appreciation without active participation.
Peer-to-Peer Lending: Returns from P2P platforms can generate passive income in the form of interest.
On the other side of the spectrum, here are a couple of examples that do not qualify as passive investments under IRS rules:
Dividend Stocks, Real Estate Investment Trusts (REITs) or Capital Gains: While they may feel passive, this is technically portfolio income, and it cannot be used to offset passive losses. Under Treasury Regulation §1.469-2T(c)(2 & 3), portfolio income is not considered income from passive activity and that includes interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business.
Your Own Business (if you materially participate): Even if you are not grinding it out every day, your involvement may still be deemed active under IRS rules.
Use Caution, Not Just Optimism
A true PIG isn’t just a tax strategy; it is an investment. That means due diligence is critical. Before jumping in, ask:
How much income will this realistically generate?
What’s the risk profile?
What’s the liquidity and redemption policy?
Does the tax benefit justify this investment?
The goal isn’t just to feed your losses; it is to feed your future wealth.
PIGs and the Bigger Picture
Finding and funding a PIG is a strategic move for investors who have already done the hard work of building a portfolio and accumulating passive losses. When used wisely, PIGs can accelerate your returns and reduce your tax liability without requiring you to qualify as a real estate professional or convert to short-term rentals.
But don’t forget the bigger picture: a good PIG should stand on its own as a solid investment. The tax benefit is icing on the cake, not the cake itself.
Think Like a Strategist
When it comes to wealth building, passive income plays a powerful role, but the IRS rules mean it is not as simple as “make money while you sleep.” Understanding the role of PIGs, and how to unlock passive losses with passive income, can make all the difference in your long-term strategy.
Think carefully. Choose wisely.
If you are considering a 1031 exchange, feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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