Hi
Could someone guide me as to what are the tax consequences as far as depreciation is concerned when your income levels from current jobs are more than $150k(combined for both spouses)? I had seen some references on this before, but I can’t remember the exact context.
Thanks
Alvin
You can depreciate property regadless of income. You cannot take passive losses in excess of income if you make more than $150K.
What this means is that if you have $10K in investment income and your expenses (including depreciation) come to $12K, then:
(1) If you make less than $150K, you can take the $2,000 “passive loss”.
(2) If you make more than $150K, you cannot take the loss, but you can show as “$0” income.
Keith
just to add to Keith’s comment, the passive loss is not lost (no pun intended) but rather suspended. This mean if you sell the property or you have a low year of income, then you can use thos epassive loss from past year. The latter method came in handy for me as I had a low income year a couple of years ago when I was self-employment and doing consulting work (made about1/2 my normal income), but was able to take a bunch of suspended loss in that year.
Let’s clarify a couple of points.
The net passive loss allowance can only be taken against other ordinary income if the loss is from a passive activity with active participation. The IRS, by default, defines rental property operation as a passive income activity. If you manage your own rental property (or, use a professional property manager, reserving certain decisions to yourself) then you are an active participant.
A passive loss from a rental property operation with active participation, is first used to offset passive income from other rental property, then used to offset capital gains from the sale of your rental property, and then used to offset passive income from other passive income activities.
Finally, if you still have unused passive losses from your rental property operation with active participation, then up to $25K of your net passive loss can be used to offset other ordinary income subject to income limits.
If you still have passive losses that can not be used, they are suspended and carried forward to the next tax year.
If you are a limited partner in a limited partnership, you have passive income, but NO active participation because limited partners have NO say in management decisions. Net passive losses passed through to you from the limited partnership, CAN NOT be used to offset other ordinary income.
The net passive loss allowance is $25K for income up to $100K. For income between $100K and $150K, the net passive loss allowance is reduced by $1 for every $2 of income over $100K, going to $0 when income reaches $150K. If your other ordinary income is $149,998 (less than $150K), your net passive loss allowance will be limited to $1, not the full $2K mentioned above.
Alvin,
I think we pretty well covered the net passive loss allowance, but there are income tax return impacts related to depreciation that were not addressed.
First, if you are a residential rental property owner, your cost recovery period is 27.5 years. If you fail to take an allowable depreciation expense, the IRS will tax unrecaptured depreciation that you took or should have taken when the property is sold. This is what “depreciation recapture” is all about. Unrecaptured depreciation is “recaptured” at a 25% tax rate, regardless of your tax bracket.
Generally, the purchase price for your investment rental property buys the rental dwelling structure AND the land it sits on. Only the structure can be depreciated – land can not be depreciated. You have to allocate your purchase price between the structure and the land, and your allocation must be reasonable and defendable to the IRS. The portion of your purchase price allocated to the structure is your “depreciable basis.”
Personal property, such as a washer/dryer or furniture that you put in your rental property for your tenant’s use can be depreciated on either a five or seven year schedule, depending upon the applicable asset class.
As you replace major components of your rental property, you create a new asset for depreciation. For example, replace the roof on your rental property, and the new roof becomes a new depreciation asset with its own 27.5 year cost recovery period.
Here is one depreciation pitfall that a lot of investors are not aware of. One of the great tax loopholes still available to investment property owners is the 1031 tax-deferred exchange. If you use a 1031 exchange to replace your partially depreciated rental property with another rental property, the adjusted basis in the relinquished property is carried forward to the replacement property and depreciated over the remainder of the old depreciation schedule.
For example, let’s say your rental property has an adjusted cost basis of $37K with 14 years still left on your depreciation schedule. The adjusted cost basis in your relinquished property becomes the initial cost basis in your replacement property, and you only have 14 years left on the depreciation schedule for this basis in your replacement property. Let’s call this basis, OLD BASIS, since it is carried over to the replacement property from the old, relinquished property.
Most likely, the replacement property cost more than the sale price of the relinquished property and you have to bring your own cash and/or additional financing to the settlement table to complete the replacement property acquisition. Any new money and additional debt that you bring to the replacement property acquisition is also included in the total cost basis in the replacement property. Let’s call this basis the NEW BASIS. The new basis is a new depreciable asset with its own 27.5 year recovery period.
So, your cost basis in the replacement property has two components, the OLD BASIS and the NEW BASIS. A lot of investors will just compute the total cost basis in the new property, and begin a new 27.5 year depreciation schedule without separating the replacement property basis into OLD and NEW basis components, each with a separate depreciation schedule.
Even a very popular and highly recommended personal tax preparation software package, TurboTax, does not automatically do this for the taxpayer. This allocation of the replacement property basis between OLD and NEW components must be manually entered into the rental property depreciation asset scheldule in TurboTax.
Hi Guys
So many thanks to all of you. When I filed this, I couldn’t have imagined that I would actually get a response. Now, I feel I know so much about this.
Depreciation Recapture as Dave mentioned is an eye opener. You could (becuase of income limitations) not get any passive icncome depreciation and if forced to sell, pay the tax on that depreciation as well. Example - Say you owned a property of $100k, could have taken depreciation of $10K for 5 years, but couldn’t, but now you sold after 5 years for $120k. So, now you pay 20% of $20K and 25% on 10K
Secondly, Dave you mention that wih limited Partnership, one doesn’t get Active participation, but I hope that’s not the case with LLC.
Again, I am really thankful to all of you.
Alvin
Alvin,
Dave and I have been discussing passive income through an LLC on a different thread. An LLC is by all accounts a limited liability partnership that has additional asset protection for the general parnter (the LLP already had limited liability for the limited partners, just not the general partner / partners).
Here is a good litmus test for you. If you have the ability to enter into a contract on behalf of your LLC then you are an active partner. The primary reason LLC’s are popular today is because the active particpants have liability protection that LLP’s did not afford them. Everything else is essentially the same as a partnership.
From a taxation standpoint an LLC may declare taxation as a corporation (although I’m still trying to figure out why that would be beneficial in Real Estate since I contend that rental income would be active income and thus subject to self-employment tax) however it’s easiest to consider an LLC a partnership with added liability protection. (Some states do not even recognize a single member LLC as anything other than a sole-proprietiorship anyway)
alvin,
You are apparently misinterpreting what I said.
The amount of your other ordinary income never disqualifies you from taking an allowable depreciation expense on your rental property.
The amount of your other ordinary income does affect whether you can use up to $25K in net passive losses to offset your other ordinary income before you calculate your tax liability.
If you have to suspend your passive losses, you do get to use them to reduce the capital gains subject to taxes when the rental property is sold.
Let’s consider your example:
Example - Say you owned a property of $100k, could have taken depreciation of $10K for 5 years, but couldn’t, but now you sold after 5 years for $120k. So, now you pay 20% of $20K and 25% on 10KIf you take $2K in depreciation expense every year for five years, then you have reduced your taxable rental income by $2K each year. Assuming that your net after depreciation is a loss (even though you have a positive cash flow) for that property, you may use that passive loss on that property to offset your taxable rental income on another property, then offset the capital gains from the sale of your rental property, and then to offest income from your non-rental passive activities (such as a limited partnership traded on the stock market in which you bought limited parthership units).
After all that, IF you still have taxable losses from your rental property that you have not used to offset passive income, THEN you can use up to $25K in net passive losses to offset your other (active) ordinary income. If your other income is so high that you are not able to use all of your passive losses, then you carry the unused losses forward to the next tax year where they might be used to offset either passive income or capital gains from the sale of your property.
The depreciation expense you claim is always used, whether or not you are able to take advantage of the passive loss allowance.
By failing to claim a depreciation expense on your Schedule E, you will have a higher rental income subject to taxes, AND, the depreciation you should have taken will be recaptured anyway when you sell the rental property.
Secondly, Dave you mention that wih limited Partnership, one doesn't get Active participation, but I hope that's not the case with LLC.There are a lot of limited partnerships traded on the stock market available for you to purchase. You can also purchase units in a limited partnership directly from the general partner during an offering period. While the IRS classifies your participation in the limited partnership as a passive activity, tax losses from your limited partnership do not qualify for the $25K passive loss allowance because you don't have active participation.
If you have an LLC that you use solely to own and operate your rental properties, then all of your LLC’s rental income and expenses are passed through to your personal 1040 and reported on Schedule E, just as if the LLC did not exist.
The IRS classifies rental property operation as a passive activity, by default. As long as you have an active role in the management of your rental properties, then you have all the tax benefits available to rental property owners just as if the LLC did not exist, to include use of the passive loss allowance should your rental operation have a tax loss for the year.
Thanks again for clarifying.
I realized I was confused between the depreciation and passive loss.
Alvin