Shades of Douglas Adams…While nowhere near as entertaining as his (increasingly inaccurately named) 5-volume Hitchhikers’ Guide to the Galaxy “Trilogy,” this series looks like it may also turn out to be a 5-part “trilogy”.
And again, let’s dispense with the legal disclaimer to keep my attorney happy:
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. ‘Nuff said.
This article and the next will continue to lay the groundwork. The idea I’m aiming for will (hopefully) be presented in article 5.
We may all bitch and moan about NAR (I know I do!) and the respective state associations. One thing they’re absolutely great at, however, is making sure that the laws — including the tax laws – in Washington DC and the state capitols are beneficial to those of us in the industry. (As a sidebar, I’m somewhat torn about these beneficial tax laws. The real estate professional side of me appreciates them tremendously every April 15th. The citizen side of me wonders what scheme Uncle Sam will think of to relieve me of those funds in another way.)
Here’s the great little real estate investment secret for those of us in the industry. It goes something like this: If you’re classified as a “real estate professional”, then there is no limit to the tax deductibility of depreciation.
Huh? Here’s what that means: If you’re a “real estate professional”, and you earn $175K per year and have $50K in depreciation, all of that is tax deductible. You simply don’t have to worry about the $150K income limit, or the $25K deductibility limit.
The IRS has some very specific rules about how you qualify as a “real estate professional.” Many NAR members wouldn’t qualify, while many non-NAR members would. The rules have to do with, among other things, what your principal line of business is, and how many hours per year you work in a real estate trade. See this IRS publication for more details.
Let’s run through the same four examples as in my previous article, comparing the tax treatment of “real estate professionals” with “normal” people.
- Let’s say you have depreciation of $10K and your income is $80K. “Normal” person
Potential tax savings: $3,000
Actual tax savings: $3,000Real estate professional
Potential tax savings: $3,000
Actual tax savings: $3,000
Verdict: No difference.
- Now let’s say you have depreciation of $40K and income of $80K.“Normal” person
Potential tax savings: $12,000 (if there were no $25K limit)
Actual tax savings: $7,500
Lost tax savings: $4,500Real estate professional
Potential tax savings: $12,000
Actual tax savings: $12,000 (since all of the $40K depreciation is tax-deductible)
Verdict: Real estate professional ahead by $4,500
- You have depreciation of $20K and an income of $140K.“Normal” person
Potential tax savings: $6,000 (if there were no $100K threshold)
Actual tax savings: $1,500
Lost tax savings: $4,500Real estate professional
Potential tax savings: $6,000
Actual tax savings: $6,000 (since all of the $20K in depreciation is tax-deductible)Verdict: Real estate professional ahead by $4500
- Finally, suppose your income were $175K and you had $20K of depreciation.“Normal” person
Potential tax savings: $6,000 (if there were no $100K threshold)
Actual tax savings: $0
Lost tax savings: $6,000Real estate professional
Potential tax savings: $6,000
Actual tax savings: $6,000 (since all of the $20K in depreciation is deductible)
Verdict: Real estate professional ahead by $6,000
Overall verdict: For real estate investors with incomes above $100K and/or depreciation losses above $25K, being classified as a “real estate professional” can have huge tax advantages.
Tags: Industry, Investing
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