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« 2012 Resolution Update | Main | Real Estate 101: Questions? »

December 14, 2012


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Complicated topic made simple. Good write-up, thanks.

In the instance that you sell a property for more than what you bought it for (and if you own it for years and years, that's probably likely just due to inflation), the gain over the original purchase price is treated as a long-term capital gain; e.g. it's not necessarily subject to that 25% depreciation capture rate.

Of course, we don't know what long-term capital gains rates are going to be in a few years, given we don't really know what they're going to be in 2013...


That is correct. Recapture capital gains only apply to the gains that are due to depreciation. Normal capital gains rates apply to normal capital gains which would be the sales price minus your basis in the property.

Travel expenses are a good deduction. The IRS lets you deduct 55 cents per mile and that adds up. Just track and log all the miles you drive related to the rental.

You can do a home office deduction too if you have a legitimate home office dedicated to rental business, but thats hard to do legitimately since its supposed to be *solely* for business use. You can't just claim your kitchen table is your home office nor can you claim the den is a home office if the den is used for other purposes. And a home office deduction doesn't add up to too much so I don't know if its worth it.

I look at depreciation as tax deferral similar to an IRA. And the 1031 I look at like doing a IRA rollover.

Doing a 1031 does have a cost generally. You have to pay a 3rd party to do it and from what I've seen the charges are around $500 ballpark. Plus doing a 1031 on multiple properties gets complicated. Say you have 5 houses and want to sell them all and buy an apartment complex. We'll you'll have to sell 5 houses and then do a 1031 exchange within the period of a couple months. That can be tricky to pull off.

If you have a LOSS on your rentals then there is a maximum on the amount you can claim as a loss. The most you can claim as a loss is $25,000 which gets cut off if your income is over $150k. Of course you should hope and plan not to have a loss.

Here's an example of depreciation and taxes : My dad bought a house decades ago for $17,000. Today its worth about $80,000. Over the years he depreciated about $14,000 of it (3k land value). If he were to sell it today he'd owe depreciation recapture on the $14,000 and long term capital gains on the $63,000 increase in value. His tax bill would be 25% of $14,000 plus 15% of 63,000 = $12,950
That works out to about 20.5% effective rate on the gain but of course the effective rate will differ depending on the gain and situation. But he hasn't sold it yet so he hasn't paid any taxes yet and he deferred $14,000 back in the 80's and 90's. (he originally had a different depreciation schedule before the law changed in '86)

I'd like more information about loss limits as Jim just touched on. Are there any pointers on dealing with taxes when your primary job hovers around the $150k income?

Also, if you were to call it quits with real estate, could you go back, live in property for awhile, sell and claim primary residence to avert any capital gains up to $250K?

Good post. A few quick adds:
* Look around for a good CPA with specific real estate investor experience. The REI's are great for this. I recommend finding one there who also has properties of their own. This one step will pay huge dividends over the years. But the run of them mill cpa does not have the deep experience in the areas you need.
* Mileage deduction is great suggestion, it really adds up, and you just need a log if you get audited.
* If you can claim 750 hours a year in your real estate business, it puts you in a much better class for several categories. Again, you need a log in case of audit.


The 750 hours is used to claim you are a real estate professional. That is mostly beneficial when trying to get around the passive activity loss rules that limits losses to 25K and to zero if you make over 150K from non-passive activities. There are not many other tax benefits than this one that I am aware of. So if you don't have significant passive losses that you are unable to deduct this isn't really that important.

It's also worth noting that 750 hours is not enough. It also has to be more than half of all your working hours. So if you have a full time job not related to real estate working 2000 hours you need 2001 hours in real estate, not 750. It's an impossible hurdle for anyone who is not full time in real estate.


You can deduct up to $25,000 of passive losses against active income (wages).

At any income above 100K this begins to phase out. You lose $500 of this deduction for every $1000 above 100K. At 150K you cannot deduct any of the loses against active income.

However these loses are not lost to you. They are carried forward until they can be deducted, either against future profits or if your income were to drop then you could use them.

As CoolMouseLuke alluded to you can deduct all loses if you can meet the hurdle to be a real estate professional. This requires documented work of 750 hours in the calendar year in your real estate business and more than half of all your working hours in real estate. If you have a full time job this is not realistically attainable.

As to pointers, if you make too much income you simply cannot deduct loses. Your only options are to make less wage income (probably not a goal) or to make your rental properties more profitable so that they do not have loses. The easiest way to do that at this time is to purchase more properties that will be strongly profitable in this market to offset the loses from your less profitable properties.

Baring that you will simply have to defer the loses until a future date.

As to living in a former rental, you can do that and you can avert part of the gains based on a percentage of time used as a rental and used as a residence. I do not know how this impacts recapture gains. I am guessing you have to pay full taxes on those but I am not certain. You would need to see a real estate CPA to get the final word on this exactly how this would all work out.

Apex -- great article, and very much in line with my philosophy about taxes on my 3 rental properties. Tax savings are a bonus, and you shouldn't count on them as part of the equation that makes a house a good rental. The depreciation just seems like deferring taxes to me, so I'm not sure why people make such a big deal out of it (though you have to take it or you'll double-pay). The biggest benefit to me (besides deducting interest as a business expense) has been deducting many of the repairs that I made to the houses before renting them out. Although you are supposed to depreciate any improvements that you make to the property, many things can simply be deducted, and that adds up (and yes it carries forward if you can't take it all in one year)! If anyone is really interested (and does their own taxes like me), Nolo Press has a great book on tax deductions for landlords.

Trying to hit the qualification as a 'real estate professional' in the eyes of the IRS to qualify your rentals as an active investment is not feasible for most people. Even if you do nothing else hitting 750 hours is quite a lot.
My dad runs 20+ units all alone including mowing lawns and all repairs and I don't think he does that much.

Most people shouldn't be too worried about the passive loss rule. You don't want to be losing >$25000 in a year to start with. And if you do have a large one time loss you can carry it forward like Apex said. If you're losing $25k then your bigger worry isn't the tax limit, its the $25k loss.
Keep in mind the 'loss' is your rental balance sheet loss on schedule F. So its all your income minus the deductions. It shouldn't be typical to have such high losses. Factoring in depreciation some good cash flow properties may show a loss on paper but hopefully not that high.

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