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Passive Income, Depreciation, and Tax Implications ~ By Chris Anderson, Ph.D.

September 6 , 2006

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"Daggumit, show me how to lose money faster" a young and naïve Dr. Anderson instructed his accountant.  "I mean, I just spent $175,000 on an investment property and I can't write that off this year but rather 27 ½ years instead?"   Fortunately for me, the accountant was patient and understanding. 

As many of you know, one of the major benefits of owning real estate is the tax benefit.  Specifically, the Government allows you to "pretend" you are losing money on a property when in fact it is really increasing in value.  On some of our investments, we were pocketing $1,000's of dollars per month tax free (well, sort of) and it is all completely legal.

In our preparation for really understanding how the Go Zone can have a major impact on investors, we have to take a step back and understand a little bit about the tax laws related to real estate activities.

Disclaimer:  We are not tax attorneys or advisors.  The information contained in this article is for educational purposes only.  Please consult your appropriate legal/tax advisor.

What Is Depreciation?

Oh, boy now we get to talk about the exciting stuff... taxes, depreciation, "root canals"..  As a real estate investor, you DO NOT need to know all the specifics however you DO need to know enough to think through the approximate tax implications of a potential deal.  Then, if it looks good to you, you can then double check with your tax advisor.

Depreciation refers to the periodical decline in value of a property due to wear and tear that naturally occurs over time. Since land never wears out, it is not subject to depreciation. Land costs even increase over time. As per the law, a residential property has a depreciation period of 27.5 years and a commercial property has 39 years, both on a straight line basis.

There are multiple methods to compute an asset's depreciation value. The simplest and most common method used is the straight-line method. The straight line method implies that the depreciation value of a property is equal every year of its useful life. The depreciation value is calculated by dividing the purchase amount of the property by the corresponding depreciation period.  So, for example, if you bought property consisting of a house and land with the house costing $200,000, you could "pretend" you lost $200,000/27.5 = $7,272 of value and potentially "write this off" your other income.  

Suppose this property actually produced $600 per month positive cash flow and actually APPRECIATED 7% this year.  From a simplistic view, we would make $7,200 in income, lose $7,272 in depreciation, and thus have a net loss of $72.  Until we sell the property, we can ignore the actual appreciation in value.   Suppose the person who owns this property is in the 33% (28% Fed + 5% State) tax bracket.  Even though they put $7,200 in their pocket, the income tax liability may actually decrease $24; without the depreciation, they would have owed $2,376 in taxes!  

We're From The Government & We're Here To Help

But why would the Government allow this.. clearly they are losing money, right?  Far from it.  This little step is what would be considered a win for the Government and a win for the investor.  Let me explain.

Rental housing availability has always been a challenging problem not just for the US Government but for many countries as well. To help solve this issue, the US Government offers tax incentives to entice investors to build housing units and make them available for rent. Otherwise, the Government would have to take on the very costly task of developing rental housing.

Another great example of the Government using tax incentives to accomplish its objectives is with the legislation known as the Gulf Opportunity Zone (Go Zone).  This Act was approved after the extremely disastrous hurricanes - Katrina, Rita, and Wilma - hit the gulf region in the middle of 2005.  It allows real estate investors to claim an additional first year 50% bonus depreciation if the property is constructed within the GO Zone by 12/31/08.  In the example above, that means we could "pretend" we lost $103,636 in depreciation!!!!   For somebody in the 33% bracket, this could POTENTIALLY mean a tax savings of $34,200.   

But watch out for the magician hand tricks.. Will you really be able to take advantage of these losses?

What Do You Mean I Can't Claim That Loss?

Now we are getting into the some real technical details that you WILL NEED professional help with but I still believe you need a layman's understanding so that you can have a good conversation with your tax advisor. 

It turns out that often we cannot immediately claim our losses (like the loss generated by the depreciation above) against our other income.  Many people found this out the hard way in the stock market meltdown a few years back where they maybe had $10's of thousands of dollars of losses however the IRS allowed many to deduct only $3,000 of those losses for the first year, another $3,000 the next year, etc.  

Why can't they claim those losses?  The simple explanation is that the IRS has special rules for deducting losses in 2 of the following 3 types of income classifications:

Active Income:     Income & losses from a job or other active participation;

Portfolio Income:  Income & losses from dividends, interest, and sale of investments like stocks, bonds, etc.

Passive Income:  Income & losses derived from trades or businesses with no material participation, and income from most rental real estate activities.

Without getting way too complicated, the IRS limits losses in activities categorized as portfolio and passive activities. Generally, passive losses can be offset with passive income, but any remaining loss is often limited. 

For example: An investor owns 2 rental properties in which he is an active participant. Property A has a loss of $10,000; property B has income of $3,000; the income and loss are netted to arrive at a $7,000 loss from rental real estate activities in which the taxpayer actively participates. The investor may or may not be able to offset his other income by the passive loss of $7,000.

Unfortunately, this applies to the losses created by depreciation and bonus depreciation as well.  Thus, if we are going to take full advantage of the "passive" losses, we then often need "passive income" to offset those losses.  However, there are some special circumstances to consider (of course, it's the IRS).

When Can You Take Passive Income Losses (Including losses created by Depreciation)

Now, we finally get down to the most important question.  For each investor, they need a layman's answer to this question for their own situation.  That way, they can rapidly assess the tax implications of an investment to see if it is even worth talking to their tax advisor.

So here is a simplified view of when you can really take advantage of these types of “pretend” losses.

1. You have other passive income (rents, leases, etc.) that can be offset by these losses;

2. If you or your spouse actively participated in passive rental real estate activities that have a net loss, you can deduct up to $25,000 of the loss from your nonpassive income (such as W-2 earnings, trade or business income, investment income, etc).   Phase-out rule.   The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of your modified adjusted gross income that is more than $100,000 ($50,000 if you are married filing separately). If your modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot use the special allowance.

3. If you qualify as a real estate professional, report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses (i.e., you can write these losses off against your ACTIVE income!)

Under the right conditions, it is quite possible that a person could use the tremendous tax savings discussed above to help pay for (or completely pay in some cases) the acquisition costs of a new investment.  Said another way, would you rather pay a bunch of money to Uncle Sam during 1 year or would you rather invest that SAME MONEY in an appreciating asset?  Hmmmm, I know what my answer is..

About The Author

Dr. Chris Anderson is the founder of one of the largest preconstruction groups on the internet today and is referenced in many venues including the New York Times and USA Today. Get access to wholesale property investments today.

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