Real Estate Investing Deductions
How much can you deduct if you invest in real estate?
Last week, we discussed the tax-free gain on sale exclusion for rental properties. Today’s topic is how much you can deduct if you invest in real estate.
Investing in real estate offers ways to offset your earned income on your tax return.
Rental Property and Your Tax Return
If you own a rental property, all expenses directly associated with it (such as mortgage interest, property taxes, maintenance and repairs, and travel to and from the rental) are tax deductible. You report these expenses on Schedule E.
Plus, even though a rental property is an asset that typically appreciates over the long term, the tax code allows you to depreciate it. This creates an additional expense that may also be deducted on your tax return.
Residential rental property is depreciated over 27.5 years or roughly 3.6% per year. Only the value of the building and other improvements can be depreciated. The land cannot be depreciated because it doesn’t wear out. Let’s take an example of a house that cost $200,000. If 80% of the value is the structure and 20% is the land, the value of the structure would be $160,000. The amount you could deduct for depreciation would be $160,000/27.5 years, or a little over $5800.
Passive Loss Deductions
In many cases, the depreciation will create a passive “loss” on your tax return. Real estate is considered a passive investment and generally speaking, passive losses may only be deducted against passive income.
But the tax code allows an exception: You can deduct up to $25,000 in passive losses against your active income (that is, your income from working or from dividends), if you meet the requirements for “active participation”. Ok, so what does that mean? Active participation means you must own at least 10% of the rental property and be responsible for significant decisions affecting it. Even if you use a property manager to manage your rental, you’ll meet the requirement for active participation if you make key management decisions (such as approving tenants and expenses for repairs).
Here’s an example of how the passive loss deduction works: Let’s say you’re single and your modified adjusted gross income is $50,000. And let’s say you have a $10,000 passive loss from a duplex you own and actively participate in. In this example, you could deduct the full $10,000 loss from your $50,000 earnings, reducing your taxable income significantly for that year.
Deducting Real Estate Losses
As long as your modified adjusted gross income is $100,000 or less, you can deduct rental real estate losses of up to $25,000 per year from your earned income, whether you’re single or married and file jointly.
OK, so if your modified adjusted gross income is $100,000 or less, you can deduct up to $25,000 in passive losses against your earned income. But what if your income is higher? For modified adjusted gross incomes between $100,000 and $150,000, the deduction phases out: it’s reduced 50 cents for each dollar your income exceeds $100,000. So if your modified adjusted gross income were $125,000, for example, you’d be eligible to deduct up to $12,500 in rental real estate losses from your earned income. If your modified adjusted gross income is $150,000 or more, you’re no longer eligible for the deduction.
But even if you’re not eligible, you don’t lose the deduction! You can carry over real estate investment losses indefinitely to future years and use them when your income falls to a level that makes you eligible. You can also use the carry-over losses to offset capital gains when you sell a rental property.
Keep in mind that when you sell a rental property, you’ll need to reduce the cost basis by the amount of depreciation you’ve taken, which makes for a larger gain. This is called “depreciation recapture”. I don’t have time to go into it in this episode, but there is a way to roll the depreciation and capital gain when you sell a rental property into the purchase of a new property to defer paying taxes on them.
Offsetting your active income with up to $25,000 in real estate investment losses is just one of the ways real estate can help you shelter your income from taxes. In a future episode, I’ll tell you about another method that lets you reap the full benefit of passive losses.
As always, it’s a smart idea to consult a tax or financial advisor.
Several of you have emailed me asking about recommended books to read to learn more about wealth creation. I’ve put together a summer reading list you can find in the Money Girl section of quickanddirtytips.com (see sidebar). On the website, you can also see the list of books I’ve given away in previous book give-aways.
And speaking of book give-aways, today I’m giving away two copies of The Beginner’s Guide to Real Estate Investing by Gary Eldred. This book has all kinds of helpful advice if you’re a beginning real estate investor or thinking about getting started. This week’s winners are Gary in Reno and Luke in Denver. Congratulations! Be sure to check your email for instructions.
Cha-ching! That’s all for now, courtesy of Money Girl, your guide to a richer life.
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o IRS Publication 527, “Residential Rental Property
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