Depreciation Can Only Offset Regular Income, Right??
Hi all,
I just bought 4 properties this year, and was planning to rent 3 out, live in 1 for two years, sell once I was eligible to exclude the capital gain, then move to house # 2..live there 2 years, sell...etc, etc. (Of course this plan assumes that the tax rules stay as generous as they are now...maybe a bad assumption.)
ANYWAY!
Then it occurred to me: what if, at some point, I have more depreciation for a particular tax year than I do "regular income" to offset? (I'm planning to cut waaayyy back on my hours in my day job.) I can't use depreciation to offset capital gains, right? (I have capital gains from investments other than real estate.)[ Edited by ouiser28 on Date 12/12/2003 ]
There is a limit of $25,000 of passive losses for offsetting earned income if the earned incoome is less than $100,000. This is proportionally reduced to 0 offset when earned income is $150,000. However, passive losses can offset other passive income. If deductions cannot be made, the losses accumulate and can be used in future years when earned income is less.
When you buy a propertie the purchase price plus some of the acquisition costs become the basis for the property. Certain improvements are added to the basis. Depreciation reduces the basis by the amount depreciated. When you sell the property you pay capital gains tax (long term, hopefully) on the difference between the selling price (less costs) and the property basis.
I hope this helpps.
Regards,
Ed
Thank you for your reply. It was very helpful, and reminded me to state my assumptions:
(1) I was assuming that, once I give up my day job and do investing full time, I would be eligible for treatment as a "real estate professional" and not subject to the $25,000 passive limitation.
AND
(2) The scenario that I had in mind was this: Assume I have no day job. I own 10 investment properties that I depreciate each tax year. I get an offer I can't refuse to sell one of my properties. But wait! I haven't done the live-there-two-years trick to get the gain exempted. So I sell and it's long-term capital gain. None of this gain can be offset by my depreciation deductions, right?
You won't get long term capital gain if you are living in a house that you sell since it is your residence (not an asset of your business). I am not exactly sure of the new rules on residences but the old rule gave you a period of time to find a new residence of greater value. This defers (or at least use to ) any gain on sale of residence. You might look this one up.
I hope that this helps.
Quote:Then it occurred to me: what if, at some point, I have more depreciation for a particular tax year than I do "regular income" to offset? If you have NET passive losses that you can't use, then you suspend some of your passive losses and carry them forward to the next tax year.
For example, let's say that you have net passive losses of $20K, $40K in earned income, itemized deductions of $16K, and a standard exemption of $6K. Subtracting your standard exemption and itemized deductions from your earned income, you have only $18K of taxable income. You only need $18K in net passive losses to reduce your taxable income to zero, and eliminate any tax liability.
On your schedule E, you would reduce your allowed loss proportionately for each property, so that your total net passive loss is only $18K. The $2K in net passive losses you can not use are carried forward to the next tax year.
Quote:I was assuming that, once I give up my day job and do investing full time, I would be eligible for treatment as a "real estate professional" and not subject to the $25,000 passive limitation.If your real estate activity is limited to managing your own rental properties, then you will not qualify as a real estate professional. By default, rental property is a passive activity regardless of your level of active participation. To qualify as a real estate professional, you must materially participate in an active real estate business in which your "personal services" total at least 750 hours AND constitute more than 50% of all your time spent in all activities.
Quote:Assume I have no day job. I own 10 investment properties that I depreciate each tax year. I get an offer I can't refuse to sell one of my properties. But wait! I haven't done the live-there-two-years trick to get the gain exempted. So I sell and it's long-term capital gain. None of this gain can be offset by my depreciation deductions, right?If you have owned your investment property at least one year, then your profit on the sale is a long term capital gain. The depreciation expense can still be taken in the year of the sale to offset your rental income. Any suspended passive losses for that property carried forward from a previous year increase your basis and DO reduce your taxable capital gain. Depreciation recapture will still apply for all allowed depreciation during your holding period. If you are in the 15% marginal tax bracket (or lower), then your long term capital gain tax rate will only be 5% through 2007. If you are in a higher tax bracket, then your long term capital gain tax rate will be 15% through 2008.
Implicit in your question is how the capital gain tax treatment works for a real estate professional who has been taking all passive losses each year against active income without regard to the $25K limitation.
A real estate professional who treats net passive losses as active losses to take advantage of relief from the $25K passive loss limitation, now has to treat the profit on the sale of that investment property as "active" income taxed at the applicable ordinary income tax rate. Capital gains tax rates do not apply in this situation.
Consult a professional tax advisor for specific details as they may apply in your personal circumstances.
Thank you so much. I see that I was combining several different issues...off to the tax advisor I go! Thank you again.
While you are at it, ask how you may take advantage of a 1031 like-kind exchange to defer capital gains when you get that offer you can't refuse.