Let me be upfront by saying that this is not my typical blog. In this week’s blog, I wanted to get something off my chest once and for all because I am sick and tired of talking to people who have been given wrong information.
Now, if you are someone who already owns a handful of rentals, you (hopefully) already know the correct answer and do not need to read this blog. However, if you are new to real estate (or if you are a seasoned investor who is curious on what I am going to write about), then keep reading…
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The No Write-Off Myth
Last week I met with and spoke to three different investors who told me that there was no tax benefit to owning real estate. Each of them had spoken with their CPAs (all different CPAs), and they were told point blank that rental real estate was not a good way to invest. So why did they call me? Well, they essentially wanted to confirm with me that they shouldn’t invest in real estate. They wanted to double check that all the strategies that I write about on BiggerPockets were not going to help them in the least bit for one reason or another and that real estate was not a tax-efficient investment for them.
What they were told by each of their CPAs was that essentially investing in real estate does not help them with taxes because:
- Their income is too high, so they do not get to use any depreciation for their rentals, and
- Their income is too high, so they cannot write-off any expenses they incur for their rental
Both of these statements are absolutely incorrect, and it really bothers me when people are given bad information. Exactly why their tax advisors provided them with this wrong information is beyond me. My only hope was that this was either an honest mistake on the advisors’ parts or that the investor had misunderstood their advisors’ message.
How You Can Use Depreciation to Offset Rental Income
First off, let me be clear that regardless of your income, you can always use depreciation to offset your rental income. For example, if your income was $1M this year and you owned a rental property that had rental income and depreciation expenses, the depreciation expenses can be used to offset your rental income exactly the same as if your total income was $10,000 for the year. There is never a limitation of how much depreciation you can use to offset rental income.
Let’s talk about expenses. Expenses, in fact, are also a very simple and straight-forward concept, and the rules are exactly the same as it is for depreciation. Basically, you can always use your rental expenses to offset your rental income.
This is true regardless of whether you make $10k or $1M this year. So if you are someone who made $1M this year, your rental expenses such as property taxes, insurance, management fees, repairs, etc. can all be used to offset your rental income without any limitations.
Now, what happens if you have an overall net loss on your rentals? Let’s say you have a cash flow positive rental property that provides you with $5,000 per year. But with the tax strategies on maximizing your write offs, your repairs and depreciation expense, you end up with a net tax loss of $2,000. The question is whether the $2,000 excess loss can be used to offset your other income (i.e.: W-2 income).
Here is where the potential limitations come in. The IRS has a rule that if you are not a real estate professional (i.e.: someone who spends more time in real estate than your other job/business), then you can use up to $25k of excess rental losses to offset your other income if your income is under $100k.
On the other hand, if your income is between $100k and $150k, then you can still use your real estate losses to offset your other income. The amount you can use just may be limited.
Once your income is above $150k, then you cannot use the excess losses to offset your other income. Those losses are saved in a bucket for you to use to offset future rental income.
Let’s take Adam for example. Adam works at a W-2 job and makes $40k per year. With rental income of $20k and expenses of $30k, Adam has a net rental loss of $10k. Since his income is under the IRS threshold, he can use the $10k of excess losses to offset his W-2 income.
Now, if Adam makes $200k instead, then he cannot use the $10k excess loss to offset his W-2 income. What is important to note is that we are not saying Adam cannot write off his depreciation or expense — he certainly can do that. He can use all his depreciation and expenses to reduce the entire $20k of rental income. He is only limited in the fact that he cannot use the excess $10k to offset his W-2.
So in Adam’s example, is real estate a good, tax-efficient investment for him? Well, it certainly looks that way to me. Adam is paying zero taxes on the $20k of rental income he received during the year. Compare that to a CD, if in the unlikely event that Adam made interest income of $20k from that bank CD (ok…yes, I know that it is impossible to make that money in a CD), he would have had to pay taxes on that entire $20k.
The same goes for capital gains. Had Adam sold stocks and made $20k, he would generally have to pay taxes on that $20k gain.
So it is important for us to understand that regardless of your income, owning real estate could be a tax efficient investment as there are no limits to expenses, and depreciation can be used to offset rental income. In fact, if Adam owned 3 properties with some profitable and some not-so-profitable, the expenses and depreciation from one rental can be used to offset the income from another rental — again, regardless of how much income Adam makes.
In addition, there are potential loopholes to allow someone with high income to still be able to use excess rental losses to offset W-2 income. The strategy is being able to qualify as a real estate professional. Keep your eyes out, as I hope to write an upcoming article to discuss the details of what a real estate professional is and also to debunk some common myths surrounding that strategy.
Do you write off your depreciation? What are your questions when it comes to real estate and taxes?
Let your voice be heard in the comments below!