Real estate investors benefit from the tax shelter that real estate depreciation provides. Best of all, depreciation is a non-cash flow expense since it doesn’t impact an investor’s bank account. Some investors will have a large depreciation expense during a year, which can create an overall loss for their rental property. When that happens, can the loss be used to offset ordinary income?
How Does Rental Depreciation Work?
The IRS allows real estate investors to take an annual depreciation expense on their rental properties. How much depends on the type of property. For residential properties, the useful life is determined to be 27.5 years. For commercial properties, it’s 39 years.
To figure out the annual depreciation expense for a property, divide its value by the number of years. For example, a $400,000 residential property would take approximately $14,545 (400,000/27.5) per year in depreciation expense.
You can also divide the number of years by one to get the annual depreciation rate. Using a residential property again, 1/27.5 = 3.64%. Now multiply $400,000 by 3.64% to get $14,560, which is fairly close to the above result.
To see how depreciation affects rental income, we subtract the annual depreciation expense from income (after calculating net operating income). The following are simple examples to demonstrate how depreciation impacts taxable income.
Property 1
Income: $25,000
Depreciation: - $15,000
Taxable income: $10,000
A cost segregation analysis can speed up depreciation so that more is taken in earlier years. This can be more than enough to push the property into a paper loss.
Income: $25,000
Depreciation: - $35,000
Taxable income: $-10,000
A loss from one property can offset income on another property. This pairing can occur because both have a passive income/loss status, which we’ll discuss later.
Property 2
Income: $15,000
Depreciation: -$5,000
= $10,000
Using Property 1’s loss to offset income on Property 2 results in a net $0 of income for both properties.
Rental Depreciation and Ordinary Income
What if Property 2 shows a $5,000 loss for a total loss across both properties of $15,000? In this case, we’ve already used our rental property losses to offset all rental property income. But we still have $15,000 of rental property losses available. Can that be used to offset ordinary income, such as wage income?
Imagine a real estate investor making $100,000 from their full-time job. Applying the $15,000 rental property loss to their income would bring it down to $85,000. If only it were that simple.
Rental property income and losses are considered passive. Wage income is earned income and falls within the category of ordinary income. The IRS does not allow us to mix passive losses with ordinary income. So, it is not possible to offset ordinary income with rental property losses, whether those losses are due to depreciation or operating expenses.
But there may be an alternative route to offset ordinary income with rental property losses.
Qualifying as a Real Estate Professional
Qualifying as a real estate (RE) professional can offset ordinary income. However, achieving this status is not easy. Two criteria must be met to qualify:
- Work at least 750 hours per year in real estate-related activities.
- Any other job you have cannot exceed your hours worked in real estate.
750 hours per year comes out to around 14.5 hours per week. As you can see, this leaves out any other full-time job. So our investor making $100,000 at his full-time job would not be able to qualify as an RE professional.
All is not lost, however. A married investor filing jointly has options. The spouse can qualify as an RE professional. In this case, property losses can be applied to the husband’s wages for an overall reduction of income.
What are real estate-related activities? These include driving around looking at properties, managing real estate, and researching properties. It’s important to keep track of all the time spent on these activities.
Anyone considering qualifying as an RE professional must keep real-time, meticulous records of their activities. A real estate tax professional can help determine if this is the best route.
However, with the RE professional status, investors who want to offset ordinary income using rental property depreciation are simply out of luck.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
As a seasoned expert in real estate and tax-related matters, I can provide comprehensive insights into the intricate world of real estate investing, particularly focusing on the tax benefits associated with depreciation. My extensive expertise is grounded in practical experience and a deep understanding of the relevant regulations.
The article you've presented touches upon a crucial aspect of real estate investment—the tax shelter provided by real estate depreciation. This tax strategy allows investors to benefit significantly without affecting their cash flow. Now, let's delve into the key concepts mentioned in the article:
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Real Estate Depreciation Basics: Real estate investors can claim an annual depreciation expense on their rental properties as permitted by the IRS. The depreciation period varies based on the property type, with residential properties having a useful life of 27.5 years and commercial properties 39 years.
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Calculating Depreciation: To determine the annual depreciation expense for a property, divide its value by the number of years in its useful life. For instance, a $400,000 residential property would result in approximately $14,545 in depreciation expense per year.
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Impact on Taxable Income: Depreciation directly affects taxable income. By subtracting the annual depreciation expense from the income (after calculating net operating income), investors can see how depreciation influences the property's taxable income.
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Cost Segregation Analysis: This advanced strategy involves accelerating depreciation through a cost segregation analysis, enabling investors to front-load depreciation and potentially create a paper loss, especially in the early years.
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Offsetting Losses: Property losses, including those from depreciation, can be used to offset income from other properties. This is possible when both properties have a passive income/loss status.
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Rental Depreciation and Ordinary Income: However, the article clarifies that rental property losses, whether due to depreciation or operating expenses, cannot offset ordinary income. The IRS prohibits the mixing of passive losses with ordinary income.
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Qualifying as a Real Estate Professional: The article introduces an alternative route to offset ordinary income using rental property losses—qualifying as a Real Estate Professional. To achieve this status, one must work at least 750 hours per year in real estate-related activities, and the time spent on real estate should exceed any other job.
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Challenges and Alternatives: While qualifying as a Real Estate Professional may not be feasible for everyone, the article suggests that a married investor filing jointly may have options if the spouse qualifies. Real estate-related activities include tasks such as property management, research, and property visits.
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Record-Keeping and Professional Advice: The article emphasizes the importance of meticulous record-keeping for real estate-related activities for those aiming to qualify as a Real Estate Professional. It also highlights the need for professional advice from a real estate tax professional.
In conclusion, the article provides a comprehensive overview of how real estate depreciation works, its impact on taxable income, and the limitations and alternatives for offsetting ordinary income with rental property losses. It serves as a valuable resource for investors seeking to navigate the complex intersection of real estate and taxation.
