The best way to use real estate depreciation is against ordinary income. These are two ways to do it.
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Investing housing Can be a risky, time-consuming, illiquid investment. However, equity is one of the best parts of being an investor in real estate (at least outside of a retirement account or a REIT structure) is that you can depreciate the value of the property’s buildings. Under current law, bonus depreciation can exceed 60% of your investment in the first year. Investing $100,000 and getting $60,000 off your taxes in the same year is pretty cool.
Unfortunately, there is a common tax doctrine that prevents many investors from actually being able to use that deduction. It turns out that you can only use passive losses to offset passive (ie rental) income. If you have no passive income, those losses are carried forward indefinitely. This is much like the long-term capital loss that many of us carry over the years Tax-loss crops Our Taxable Mutual Fund Portfolio. These losses offset any long-term capital gains you may have had, and you can use $3,000 per year against your ordinary income. But after that, they are simply carried.
However, there are two ways to use those passive real estate losses against your ordinary income instead of waiting until you have enough rental income. That is the real victory. Not only do you have to wait years to use them, but you can use them to offset income that would normally be taxed too much.
Method #1 Real Estate Professional Status
If you qualify as a Real estate professional, you can use real estate losses against your ordinary income. Unfortunately, this is pretty hard to qualify for unless you actually have at least a part-time career in real estate. There are two basic requirements:
- You must work at least 750 hours a year in real estate (that’s basically half time, 17 hours a week or more year-round) and
- You can’t do anything but real estate.
This excludes virtually all doctors and similar high-income professionals who are practicing full-time. However, some doctors still manage to pull this off by getting their spouse to become a real estate professional or transitioning from medicine to real estate (i.e., dramatically downsizing medicine). You can still practice medicine part time; You just need to do more in real estate.
Obviously, it’s going to be a tough sell to the IRS that you spend 750 hours a year in real estate if you only own one or two properties and maybe a passive syndication or a fund. When you do this, you’re really +/- committing to manage a whole bunch of properties—less if they’re long-term rentals and you hire a manager, if you manage yourself.
This leaves most of my readers (and me) with Method No. 2 as the only option, although be aware that if your properties are short-term (less than seven days rent on average), there is a loophole that makes qualifying much easier.
Method #2 Selling property (ie using the 1231 loss)
This method is a bit more interesting, and it takes a minute to wrap your mind around. This is especially difficult to do if you understand the real estate investment doctrine of depreciation, exchange, depreciation, exchange, depreciation, death. I mean, should real estate investors never sell?
Well, if you invest passively, using private syndication or funds, 1031 exchanges from investment to investment can be surprisingly difficult. Most don’t allow you to do 1031 inches. So every 5-10 years, the asset is sold and you are paid. The key comes down to what happens during investing.
In year 1, you get this big fat bonus depreciation. There may be some additional depreciation after the first year. You can’t really use it in those early years (not enough income distributed), so you carry it forward. This is used to offset the income from the property over the years, so that it all comes to you tax-free. However, when it’s time to sell the property in 5-10 years, you’ll likely still have some left over. What is that used for? That is the key.
Many of these resources are governed by section 1231 Section 1231 assets include:
- Section 1250 Assets (non-assessable buildings),
- Section 1245 Assets (depreciable things inside buildings), and
- Land (which you cannot underestimate).
In passive real estate investing, most of what you get is a 1250 asset loss. The rules on these are very different from the rules on capital gains and losses In the capital gain/loss world you may be familiar with from your mutual fund investments, short-term losses offset short-term gains and long-term losses offset long-term gains, and only $3,000 of the loss can go against your ordinary income. However, the 1231 world is different. Long term capital gains (LTCG) is taxed at the 1231 tax rate. But 1231 losses are fully deductible as ordinary income against taxable income. Let me repeat that because this is the main point.
1231 gains are taxed at LTCG rates but losses can be deducted at ordinary income rates.
So, when you end the life of your syndication and the property is sold, you will have to pay tax on the gain. Assuming you’re in the highest bracket like many syndication investors, you’ll pay 25% on recaptured depreciation and 20% on any gains above that (the long-term capital gains rate, actually 23.8% when you include the PPACA tax). These taxes are the price you pay for selling the property rather than exchanging it, and in some ways, the price you pay for being a passive real estate investor (another is that you’ll probably have to file a bunch of nonresident state tax returns).
But what about the loss of those you didn’t use? What will happen to them? They are used against your ordinary income for that year. Pretty cool, huh? Real Estate Depreciation Lowers Your Taxes! Now, it’s not as cool as what you get under REPS, but it’s still a kick in the teeth — and if the REPS person sells the property instead of exchanging them, the two methods are really equal. Losses and gains need not accrue to the same property. If you sell one in the same year you buy the other, you can still use those losses against your ordinary income to the extent of your gain from the property sold.
Real estate investing comes with many unique tax benefits. The most important is Depreciation And the best way is to use it against ordinary income whenever possible. These are two ways to do it.