3 Common Ways to Access Tax Depreciation Benefits from Real Estate
By Christopher Levarek
“Prosperity belongs to those who learn new things the fastest.”
- Paul Zane Pilzer
One of the great benefits of real estate is tax depreciation, or the depreciation of the real estate asset. This allows for a loss on paper which can offset income earned. These depreciation benefits are put in place by the tax code to stimulate and create incentives for investments into real estate. For a great book on this subject, we recommend “Tax-Free Wealth” by Tom Wheelwright, the CPA of Robert Kiyosaki author of “Rich Dad, Poor Dad”.
When it comes to depreciation on real estate there are typically three buckets that an investor can fall into :
Passive (investor)
Active (Investor)
Real Estate Professional
Although these are not the only categories and there are additional possible alternatives to realizing tax depreciation, we will leave those to more qualified individuals or CPAs. Additionally, an investor can fall into all three categories and not necessarily belong to only one.
For now we will address how someone falls into one of those categories when investing, how to change categories and what are the benefits of each for utilizing tax depreciation.
Passive
In this category, the investor purely and only invest passively into a real estate deal or investment. The investor provides capital for investment and realizes passive income or “mailbox money” with very little involvement on the deal.
In this case any tax depreciation benefits on the real estate asset are passed on to the investor however, the investor can only use these “passive losses” against the passive income. So the investor would not be able to write off losses against W-2 income for example.
This is common option for those who want a hands-off investment and are looking for passive income while they focus on their main passion, job or family.
Summary : Passive losses are offset against passive income.
Active
In this category, the investor invests into active and/or passive real estate investments. The investor needs to actively manage at least some of the projects to realize tax depreciation benefits as an active investor. If the investor manages elements of a real estate to include managerial decisions, property management, repairs/matenance, etc, this qualifies as an active investor.
In this case, the investor is capable of using up to $25,000 in passive losses from real estate to offset ordinary income unless the Adjusted Gross Income of the household is $150k if filing jointly as a married couple. If the AGI is higher than $150k, the passive losses allowed changes. This can be a great method to realize some tax depreciation against W-2 income simply by having a few active investments in real estate.
Summary : Passive losses up to the amount of $25,000 are offset against ordinary income if Adjusted Gross Income is less than $150,000.
Real Estate Professional
In this category, the investor invests into active and/or passive real estate investments. The investor is capable of deducting 100% of passive losses against ordinary income if qualified as a real estate professional. If married or filing taxes jointly, it only matters that one of the couple are a real estate professional to realize these benefits.
To qualify as a real estate professional, the following two part test needs to be met :
The taxpayer must spend the majority of his or her time in the real property business, AND;
The taxpayer must spend at least 750 hours or more in the real property business and rentals in which he or she materially participates
As long as one person meets these criteria, the taxpayer qualifies as real estate professional and can realize the amazing tax deductions in this category. It is usually easiest for those who are actively working full-time in real estate related activities or those married couples with one W-2 job income thus allowing for the other person to qualify as a RE professional.
Summary : 100% of Passive losses are offset against ordinary income for qualified Real Estate Professionals.
In Final
These three categories are most typical however again there are numerous credits and incentives for realizing and using tax depreciation on real estate. We highly recommend consulting a real estate CPA to determine which best applies in your situation and present your goals. If you don’t yet fit in a specific category or would like to get further depreciation benefits, a CPA will be able to suggest ways to get there. Invest Smart!