By Dr. James M. Dahle, WCI Founder
Investing in real estate can be a risky, time-consuming, illiquid investment. However, one of the best parts of being an investor in equity real estate (at least outside of a retirement account or a REIT structure) is that you can depreciate the buildings on the property. Under current law, bonus depreciation can be over 60% of your investment in the first year. It's pretty awesome to invest $100,000 and get a $60,000 deduction on your taxes that same year.
Unfortunately, there is a general 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 (i.e. rental) income. If you don't have any passive income, those losses are simply carried over indefinitely. This is a lot like the long-term capital losses that many of us carry around for years after tax-loss harvesting our taxable mutual fund portfolio. Those losses offset any long-term capital gains you may have, and you can use $3,000 per year against your ordinary income. But after that, they are simply carried over.
However, there are two ways to actually use those passive real estate losses against your ordinary income rather than waiting until you have enough rental income to use them. That's a real win. Not only do you not have to wait years to use them, but you can use them to offset income that would normally be taxed very highly.
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, it's pretty hard to qualify for this unless you actually have at least a part-time career in real estate. There are two basic requirements:
- You have to work in real estate at least 750 hours a year (that's basically almost half-time, averaging 17 hours a week or so throughout the course of the year) AND
- You cannot do anything else more than you do real estate.
That pretty much eliminates all doctors and similar high-income professionals who are practicing full-time. However, some doctors still manage to pull this off by either getting their spouse to be a real estate professional OR transitioning out of medicine into real estate (i.e. cutting back on medicine dramatically). You can still practice medicine part-time; you just have to do real estate more.
Obviously, it's going to be a hard sell to the IRS that you spend 750 hours a year on real estate if you only own a property or two and maybe a passive syndication or a fund. When you do this, you're really making a commitment to buy +/- manage a whole bunch of properties—more if they're long-term rentals and you've hired a manager, fewer if you're doing the management yourself.
That 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 (an average rental of less than seven days), there is a loophole that is much easier to qualify for.
Method #2 Selling Properties (i.e., Using 1231 Losses)
This method is a little more interesting, and it takes a minute to wrap your mind around. This is especially hard to do if you understand the dogma in real estate investing to depreciate, exchange, depreciate, exchange, depreciate, die. I mean, aren't real estate investors supposed to never sell?
Well, if you're investing passively, using private syndications or funds, it can be surprisingly hard to 1031 exchange from investment to investment. Most simply don't allow you to 1031 in. So every 5-10 years, the assets are sold, and you're paid out. The key comes in what happens over the course of the investment.
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 all in those early years (there isn't enough income distributed), so you carry it forward. It is used to offset the income from the property over the years, so that all comes to you tax-free. However, you probably still have some left over when it comes time to sell the property in years 5-10. What is that used for? That's the key.
Many of these assets are governed by Section 1231. Section 1231 assets include:
- Section 1250 assets (depreciable buildings),
- Section 1245 assets (depreciable stuff inside of buildings), and
- Land (which you can't depreciate).
In passive real estate investing, mostly what you are getting is losses on 1250 assets. The rules on these are very different from the rules on capital gains and losses. In the capital gains/losses 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 in losses can go against your ordinary income. However, the 1231 world is different. 1231 gains are taxed at the long-term capital gains (LTCG) tax rates. But 1231 losses are fully deductible as ordinary income against taxable income. Let me say that again because it is the key point.
1231 gains are taxed at LTCG rates but losses are deductible at ordinary income rates.
So, when you get to the end of your syndication's life and the property is sold, you will owe taxes on the gains. Assuming you're in the highest brackets like many syndication investors, you will pay 25% on recaptured depreciation and 20% (the long-term capital gains rate, actually 23.8% when you include PPACA tax) on any gains above that. Those taxes are the price you paid for selling the property instead of exchanging it, and in some ways, one of the prices you pay for being a passive real estate investor (the other being that you'll probably have to file a bunch of nonresident state tax returns).
But what about those losses you haven't used up? What happens to those? They're used against your ordinary income that year. Pretty cool, huh? Real estate depreciation lowers your taxes! Now, this isn't quite as cool as what you get under REPS, but it still beats a kick in the teeth—and if the REPS person sells properties instead of exchanging them, the two methods are really about equal. The losses and the gains don't even have to come on the same property. If you sell one in the same year you buy another, you can still use those losses against your ordinary income in the amount of your gains from the sold property.
Real estate investing comes with a lot of unique tax advantages. The most important is depreciation and the best way to use it is against ordinary income whenever possible. These are the two ways to do it.
What do you think? How do you use your real estate losses? Comment below!
Featured Real Estate Partners
I’m a highly compensated physician and also an entrepreneur. My spouse decided to manage our real estate investments this year specifically to qualify for REPS. I already bought several new properties and am about to close on an 83 unit apartment building. My spouse is a designer and is overseeing a complete renovation of one of our investment properties, a labor of love to rack up REPS hours.
The bonus depreciation will likely shelter our entire income this year from federal taxes. We did have to use leverage to achieve this, but the apartment building should do very well, with plans to force appreciation. First year returns on the investment, between forced appreciation and tax savings will be over 100% on the cash we put into the deal. Some of that return is tied up in the property, long term, and simply adds to our net worth, but the property will generate ongoing annual income, and some of that first year return is in the form of tax savings.
At the same time, we will be providing quality, affordable, middle class housing and we will be adding amenities that enhance quality of life for families with children and for families with pets. The goal is for it to be a win for the tenants with enhanced amenities that add value for them, and a win for us with growth in the value of our investment. The tax laws are structured to favor real estate investments, and to some degree that makes sense given our country’s severe lack of sufficient housing.
Don’t forget to subtract the value of your spouse’s time when calculating your returns!
I do love seeing a landlord excited to provide great housing instead of just interested in making money though.
My wife and I actively invest in real estate through direct ownership. We started about a year ago and have build a portfolio of 3 properties and 8 doors so far. We invest locally in Buffalo NY so we self manage. Each month, we make about $5-6K from these properties after mortgage and other expenses. My wife will be using REPS this year to offset our real estate and other active income.
REI is obviously such a powerful wealth building tool. Education and mentorship however is critical!
Everybody I know who’s made money, has done so through mentor ship or partnering with somebody else’s organization. Going out on your own can be a disaster. I use the management company I didn’t know and had no connection with, it was a complete mess. I have Been reluctant to directly invest in real estate ever since.
I bought a property in cash in 2013 that has low expenses. So I pocket most of the rental income. Each year the accountant has been able to offset all the rental income so there is no additional tax owed for the rental income.
What will happen when I sell the property?….do I just pay taxes on the property appreciation (ie difference between what I sell it for and what I bought it for?). I remember hearing that the “depreciation will be recaptured”….but I don’t know what that means.
THanks!
You’ll pay capital gains on the amount between what you bought it for and what you sell it for and you’ll pay 25% on depreciation recapture for everything you depreciated to give you all that great “tax-free” income.
You can avoid that taxation by exchanging instead of selling, but it does mean the new property starts with a lower basis.
Thanks.
1) Just to clarify: 25% depreciation recapture means you add up all the depreciation over the many years of ownership and then pay 25% on that?
2) In terms of exchanging, can I buy a property in a different state and have it still count as an exhange?
Thanks!
1. I think it’s technically recaptured at your ordinary income tax rate up to a maximum of 25%. So for most on this site, 25%.
2. Yes
So if you have a net loss, there is no depreciation recapture?
There still could be. But if the capital loss is more than you have depreciated then there would be no recapture. But you’d have a lousy investment!
There is another place that many in this audience may be able to use those depreciation losses! Anyone who owns part of a surgery center can offset their earnings with the passive real estate losses. The only stipulation is that you cannot be an active manager of the surgery center (ie director, board member, etc) then it becomes active income.
My real estate investments have done very well over the years but I’ve always had to carry over the depreciation since I couldn’t convince my wife to get REPS status. Once I was able to buy into a surgery center I’ve not had to pay a cent in taxes on the dividends!
I believe that’s correct. I think both businesses would be in the same taxation category of passive but ordinary income.
My CPA was taking about this as well. On the entrepreneurial side of things, I have started several businesses over the years. He said there are two options. One is for the spouse to get REPS, and to then take the real estate paper losses against active income. The other option is to structure some of the business income as passive income, and to then take the real estate losses against the passive income. So bottom line, the strategy is to structure your affairs to have lots of active losses to offset active income, or alternatively, to have lots of passive losses to offset passive income. The CPA seems to think there are some fairly easy strategies and structures to accomplish one or the other.
My situation is very similar to yours. I am married filing jointly where my wife is a real estate professional and I am a highly paid W-2 professional that has been using real estate losses to offset active W-2 wages, but I hear that there is a limit that was imposed recently, do you or anyone know what that limit is on passive real estate losses offsetting earned income/W-2 wages for real estate professionals and how it works?
My situation is very similar to yours. I am married filing jointly where my wife is a real estate professional and I am a highly paid W-2 professional that has been using real estate losses to offset active W-2 wages, butI understand there has been some recent changes in limitations on how much passive losses can be used to offset wages/W-2 income. Does anybody know about the new rules and where I can find more details?
Those changes aren’t recent. If you don’t have real estate professional status, you can’t put passive losses against active income.
I have to admit, this is a new one for me (1231). Given this differential tax situation, do you have recommendations for syndications/passive real estate vehicles that provide significant depreciation without simply round-trip losing money?
I don’t know of any funds or operators that specifically focus an investment on that particular tax benefit. They’re mostly focused on providing a solid investment benefit without consideration of tax benefits. In fact, I’ve been a bit disappointed to learn what a poor understanding of the tax code many professional real estate investors possess.
I have another question, now that the wife has REPS for 2021.
Let’s say, hypothetically, that my combined income from W2 physician work, real estate income, and S-corp business income equals 1MM for 2021. And let’s say, hypothetically that my potential bonus depreciation deduction based on real estate cost segregation studies could be 1.5MM. That would potentially wipe out all federal tax liability for 2021.
What is the best strategy in this circumstance?
Is there an option to do cost segregation and accelerated depreciation on only some of the properties in 2021? To save some cost segregation studies on certain properties strategically to create more deductions for 2022? Could the strategy be to use bonus depreciation to get down to a MFJ taxable income of $81,051, that would get me down to a federal marginal tax rate of 12%?
I agree with your idea to use those losses only against the income in higher brackets so if you could do that by delaying purchases and cost segregation studies I would do so.
Use this large depreciation event to roll over any IRA balances to a Roth IRA so that you can put more income into the highest tax bracket, Benefit sooner from tax free growth, and benefit the most during your cost segregation/bonus depreciation years. Also, a Roth has no required minimum distributions and a 10 year drawn downtime when it becomes inherited whereas an IRA has RMDs and can only be drawn out five years when inherited. We are both in almost identical boats and we should talk. My email address is: [email protected]
Inherited traditional IRAs can also be stretched 10 years and there are no RMDs. But of course withdrawals are taxable so most don’t wait until year 10 to take the whole thing out like they would with a Roth IRA.
You can only stretch to 10 years if you’re the spouse of the original IRA owner, chronically ill or disabled, a minor child, or not less than 10 years younger than the original owner, otherwise, you have to distribute in 5 years. It is confusing, but this is my understanding of the traditional IRA rules. I just did some state planning for my parents where we did a ROTH conversion to get the extra 5 years of tax free growth and made the beneficiary a Nevada Dynasty Trust to keep it out of family member estates for 365 years. If anyone needs a rock star estate attorney, Alan Gassman is fantastic.
He can’t be that fantastic if that’s what he told you. 🙂
Seriously though, under current law you can stretch both traditional and Roth IRAs for 10 years no matter what your relationship to the deceased. If they died before a certain date, you can be grandfathered into the old laws, but for anyone dying now, it’s 10 years. Maybe Ed Slott will convince you if I haven’t:
https://www.irahelp.com/slottreport/10-year-payment-rule-and-2022-post-death-required-minimum-distributions-today%E2%80%99s-slott
It appears you are correct. There is a lot of confusion in this area, especially since the Secure Act. I have a zoom call scheduled at 1 PM today and I will bring it up with his associate. It wasn’t Alan Gassman that told me that, rather his associate. It won’t change our plans, but it’s important that he not believe that this is true. Am I reading on Schwab, five years only applies to estates where there is no designated beneficiary, maybe this is where his confusion came in. Thank you for being persistent and sticking to your apparently correct “guns“. Estate planning for those with assets over 20mil, is fascinating and the stakes are 40% if you hide under a rock. Members should be cautious about allowing their parents estates to enter their estates rather than going into trusts (Preferably dynasty trust) as it compounds the members estate tax planning.
Fascinating, complicated, and expensive. It takes a lot of planning to reduce that 40% tax.
So the year the syndication property is sold, any leftover year 1 bonus depreciation or depreciation from cost segregation analysis can be used to off set any kind of (active) income? How do you do that?
GeriatricPeds asks how you do that?
Well, you do it very carefully!
Newbie question. Just getting my feet wet with syndications. Is 1231 something most tax attorneys/CPAs should be familiar with? Gains taxed at LTCG tax rates, 1231 losses fully deductible as ordinary income against taxable income, recaptured depreciation are tricky. Is this info on the K-1s or is more extensive bookkeeping needed to keep track of what you carry forward and when to deduct, etc. Thanks!
It would be helpful if your CPA has a lot of other clients that are real estate investors for sure.
The info should be on the K-1s.
The suspended passive losses that accrue from year to year are not §1231 losses. Suspended passive losses are created when the rental income minus expenses like depreciation, property taxes, repairs, etc. is less than zero. The depreciation expense contributes to the loss.
§1231 losses are losses on the sale of §1231 assets, which is depreciable property used in a trade or business for more than a year. The only time you’d have §1231 losses in the context of real estate is if you recognize a loss on the SALE of the property itself which is different than the losses from OPERATING the rental.
To determine the gain or loss on the disposition of property, you take the sale price and subtract any transactional costs and then the adjusted basis of the property being sold.
The adjusted basis is the original cost less any accumulated depreciation.
For example, if I buy a $1M commercial property and claim $400,000 of depreciation expense over the years, my adjusted basis is $600,000.
I would need to sell the property for less than $600,000 to even have a §1231 loss.
If I sold the property for $500,000, I’d have a $100,000 §1231 loss.
If I sold the property for $700,000, I’d have a $100,000 gain the character of which is unrecaptured §1250 gain taxed at a maximum 25% rate as laid out in §1(h).
If I sold the property for $1.1M, I’d have a $500,000 gain, $400,000 of which is unrecaptured §1250 and $100,000 of which is a §1231 gain which is treated like a long-term capital gain.
I think you got the effect of freeing up suspended passive losses correct because they do offset your ordinary income but called it the wrong name.
Thanks for the info David Glenn.
To expand your example further.
What if throughout the course of the syndication you used $300,000 of your $400,000 of depreciation to offset Operating Income.
At the time of sale you would have $100,000 of depreciation that has not been utilized.
How would that remaining amount be treated? (For the $1.1M example).
Would it be an allowed passive loss on Schedule E? In which case it would offset Ordinary Income.
So would you have the following on the 1.1 M sale:
$400,000 taxed as depreciation recapture at 25%
$100,000 taxed as a LTCG
$100,000 of passive loss offsetting Ordinary Income
Yes, high income individuals cannot use passive losses against active income unless they file a joint return with a RE Professional or they are a RE Professional, but just recently on the Impact Theory podcast with Tom Bilyeu and Tom Wheelwright, CPA where if I heard correctly that RE Prof status only offsets business income plus $500,000 and that it does not offset wages. I thought I heard him say the change was recent ~2019/2020. He said that you would need to change the nature of your wages to passive income. Maybe I heard wrong, so I am looking to confirm this as this has been an extremely powerful strategy I wish to continue.
I don’t think that’s true. I think it can used against all taxable income, including earned income. There are a lot of docs out there using it to offset clinical income, which is often W-2.
Agreed, but if you here differently, let me know!
Another newbie question here. Have owned a condo since 2008 and have been depreciating it since I moved out of it and turned it into a rental (basically right as med school began). Now in my second year as an attending and hence now for the first time am doing my taxes for a full year’s worth of attending wages. Nasty shock to me to now discover that the approx $3k paper loss of the condo (thanks to depreciation) can’t be used to offset my W-2 income since I now make too much to qualify to use that w/o having REPS (SO is a physician as well so she can’t get REPS either).
Two questions then:
(a) how does the $3k passive loss of the condo ‘carry over,’ if at all? I’ll be an attending for the next thirty years or so, so my income will be high enough that I can’t claim it in the next year or so. Is it simply passed on and on for the next 30-ish years?
(b) does anyone know if I can voluntarily take a lower depreciation amount this year instead, such that my net on paper will be $0? This would slow the rate of the capital gain basis change, as I might be selling the condo in the next year or so
Thx!
You’ll be disappointed to learn that student loan interest also isn’t deductible to attendings.
a) You just keep carrying it forward. You can use it against passive income.
b) You can use different methods that assist with that, but I’m not sure you can change horses mid-stream. Either way, at sale it all evens out.
Thanks for this post. My wife and I are newbies at this. We are both physicians (both W2) and have a rental property. We have been carrying forward the losses yearly, and understand that can’t deduct this against active income unless one of us switches to part time and obtains REPS status or our income drastically falls.
My questions related to this
1) If we can hypothetically obtain other passive income, can we use the deductions from the rental property to offset the new passive income?
2) would incorporating (LLC etc) for owning rental properties big picture change being able to deduct the deductions?
3) Would a change in one of our income from W2 to 1099 hypothetically have an impact on this?
Thanks!
1) Yes, like losses from one property against income from another property. That happens all the time.
2) Incorporating isn’t an LLC, but forming an LLC doesn’t affect deductions at all. You’re likely still going to be taxed as an individual or partnership.
3) Not really.
I am not sure I understand bonus depreciation—- does this let you depreciate 100% of your rental purchase the year you buy it or can you only depreciate money you put into capital improvements of said property?
I am married filing jointly, my spouse is stay at home mom. We are looking to start buying rental investment properties soon, but likely is too late in year to claim real estate professional status, though we would like to make this happen in the future. I do have k-1 income of about 250k annual as owner of surgical hospital but i go to board meetings and we owners actively participate in decision making for the hospital, so not sure if this truly considered passive income. Would love to buy a property this year and depreciate it to offset as much of that K-1 income as possible——but, i would be stretching to come up with down payment to purchase a property, much less have a substantial amount of cash lying around to use towards capital improvements.
1—Could i use depreciation of a purchased rental
Property this year to offset my K-1 surgical hospital income?
2— How can i maximize my real estate deductions against this income with no cash available for capital improvements?
Surgical hospital sounds active to me. So no depreciation can be put against it.
Remember you can only depreciate the improvements too, i.e the building, not the land.