Depreciation to wipe out taxes from early IRA distribution?

[David B.]

Let's say i take an early distribution from my IRA, and buy a rental property.

Can I use the new accelerated depreciation to wipe out the taxes that I have to pay on this distribution?

[Michael Plaks]

@David B.

The short answer is no - if you expect to take out $100k from an IRA and somehow offset it with a $100k loss from real estate. Does not work this way.

More details now.

1. The whole concept of rentals reducing your taxes is this: you collect $10k in rent but take $15k in deductions. This creates a loss of $5k. Now, you do NOT save $5k on taxes! You reduce your other income by $5k. Example: you have a job with a $80k salary. Instead of paying taxes on $80k, you will now pay taxes on $75k, after deducting this $5k real estate loss. This can save you $1k-$2k on taxes.

2. Depreciation is not something stand-alone. It is included in the $15k deductions I mentioned in my example. Accelerated depreciation (which, by the way, is not new, just somewhat improved recently) may allow you to increase these deductions. So instead of $15k deductions you may have $25k deductions and increase your loss by $10k.

3. If you take a $50k IRA distribution, your income goes up by $50k. To offset it, you would need $50k of losses, which is not possible with any kind of depreciation. The maximum real estate loss you're allowed in one year is $25k.

4. That $25k ceiling gets lower as your income goes up and exceeds $100k. Income includes the IRA distribution itself! So if you have a $60k salary and take $50k from your IRA, your income is now $110k, and you're over the $100k. Your $25k limit on losses will shrink down to $20k at $110k income. At $150k income, it disappears completely: no losses allowed at all. And this income number is a combined family income if you're married.

5. Even if you take a $25k IRA distribution and are eligible for the full $25k real estate loss, with accelerated depreciation and what-not - you still pay more taxes! This is because there is a 10% penalty on yearly (before you're 59.5 yo) IRA distributions. This penalty cannot be offset by any losses. 10% penalty on $25k is $2,500.

Bottom line: early IRA distributions are usually a very bad idea. You need to discuss it with a tax pro to explore your specific financial situation and consider your options. For instance, as @Carl Fischer mentioned, you might be able to buy the property inside your IRA and avoid taxes altogether. It's complicated, so professional help is highly recommended.