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Financial Alchemy: Depreciation, Passive Losses, Real Estate Professionals, And Uncle Sam (Part 2 — Further Introduction)

Kevin Boer, Broker Owner, 3 Oceans Real Estate, Inc. ()

October 28th, 2007 · No Comments

warning1.jpgSame caveat as last time:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.

In my first post on this topic, I introduced the basics of the tax treatment of depreciation of real estate investments.  This post and the next one two will continue with the basics, and then I’ll follow up with an idea I have that may — or may not be — a creative use of this stuff.

In their continued infinite social-engineering wisdom, our wise and benevolent leaders have decided that while they want to encourage real estate investing, they don’t want to encourage it too much.  In particular, they really don’t want folks making more than $150,000 a year to gain from the depreciation benefits.

Here’s the rule they’ve set up:  The maximum amount of “passive losses” (which includes depreciation) you can deduct if your income is $100,000 or less is $25,000.  Between $100,000 and $150,000 per year, you lose fifty cents on the dollar of deductibility.  At $150,000 per year and above, you are not allowed to deduct any passive losses.

Four quick examples will illustrate.  Assume in each case that your income is taxed at 30%.

  • Let’s say you have depreciation of $10K (under the $25K limit), and your income is $80K (under the $100K threshold).   Your normal tax would be 30% of $80K = $24K.  With the $10K deduction, you’re only taxed on $70K, for a total of $21K.Potential tax savings:  $3,000
    Actual tax savings:  $3,000
  • Now let’s say you have depreciation of $40K (above the $25K limit) and in income of $80K (still below the $100K threshold).  Without the $25K limit, your tax savings would be 30% of $40K or a whopping $12K.  Since you’re only allowed to deduct $25K, your actual tax savings would be $7,500.  Still not bad, but of course not as good as the $12K to which you would have been entitled without the limit.  (Note:  I’ll leave it to folks far more expert in this than I to explain the intricacies of what Uncle Sam lets you do with the $15K you couldn’t deduct.)Potential tax savings:  $12,000 (if there were no $25K limit)
    Actual tax savings:  $7,500
    Lost tax savings:  $4,500
  • You have depreciation of $20K and an income of $140K (above the $100K threshold).  Since you lose 50 cents of maximum deductibility for ever dollar you earn above $100K, and you’re earning $40K above $100K, you lose $20K out of the maximum deductibility of $25K — in other words, the maximum you can deduct is only $5K.  At a tax rate of 30%, that amounts to $1,500 in savings.Potential tax savings:  $6,000 (if there were no $100K threshold)
    Actual tax savings:  $1,500
    Lost tax savings:  $4,500
  • Finally, suppose your income were $175K and you had $20K of depreciation.  Since you’re above the $150K income limit, you’re not able to use any of the $20K of depreciation.Potential tax savings:  $6,000 (if there were no $100K threshold)
    Actual tax savings:  $0
    Lost tax savings:  $6,000

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