1. First if you have a gain on rental property is it taxed as ordinary income?
Your net rental income is ordinary income and taxed at your ordinary income tax rate.
If you sell your rental property, any gain on the sale is a capital gain and taxed at the capital gains tax rate in effect at the time of the sale.
2. Is there a limit to offsetting passive income with passive losses?
No, As a general rule, passive losses can only be offest by passive income. Passive losses that exceed passive income are carried forward to the next tax year when they they are first used to offset passive income.
There is an exception to this rule for rental property. If you have passive losses from your rental property that exceed your passive income, then up to $25K in net passive losses from your rental activity can be used to offset other ordinary (active) income on your 1040, subject to income limitations.
3. When I do start renting i will manage everything myself so i would be considered an active participant which from my understanding means you get a special allowance of 25000 towards non passive income. However me and my wife do make more than 150000 from our jobs so this loss would be disallowed but if we have losses they can be carried forward.
This is mostly correct. Just need to clarify one point. The passive loss allowance is your net passive rental loss UP TO $25K. If your net passive rental loss is only $12K, then you get to offset your other ordinary income by $12K. If your net passive rental loss is $40K, then only up to $25K can be used to offset other ordinary income. The actual amount allowed will be limited by your modified adjusted gross income. MAGI at $150K and above, the net passive loss allowance is $0.
You don’t really need to do everything yourself. You can outsource property management and still be an active participant if you reserve certain management decisions to yourself. For example, if you reserve to yourself approval of all new tenants, determine rents and/or rent increases, and all major repairs or replacements require your approval, you are still actively participating in your rental activity even though the management company handles all the day-to-day details and does the majority of the physical work.
4. Long Term capital gains are taxed at 15% and depreciation recapture is taxed at 25% i Believe i read if you have losses that have been carried forward you can apply them at the time you sell the asset so if you aquired a house at a cost basis of 20000 and sold it for 40000 and you never depreciated it you would pay 15% on the 20000 profit. But if you carried a loss forward say 5000 and applied it at the sale you would pay 15% on 20000 profit and 25% on 5000 for recaptured depreciation or would it reduce you profit by 5000 and make you have a profit of 15000 which you would pay 15% on? If the first example is right it seems to me that you wouldnt want to apply your carried forward loss at the time of sale? If the second example is right and you had depreciated before but still had losses to carry forward would it reduce the amount you had previously depreciated or your profit amount?
Your understanding is a little imperfect.
First, unrecaptured depreciation is taxed at 25% whether you take the depreciation or not. The IRS taxes the depreciation you should have taken even if you declined to do so. So, since you are going to be taxed on it anyway, you may as well reap the tax benefit of depreciation.
Here is an article I wrote some time ago on how depreciation recapture works.
Investors have long known that depreciation on depreciable real estate is an economic fiction. Since property values usually increase over time, depreciation has often been called a “phantom” expense. Congress even recognized this fact and instituted changes to the US tax code that introduced what is known as “depreciation recapture.”
Suppose you buy $75,000 of depreciable real estate and depreciate it by $10,000 during your holding period. The property’s book value (cost minus depreciation taken) would then be $65,000.
Now by selling the property for anything more than $65,000, you demonstrate that your $10,000 of depreciation was a phantom expense. The property did not depreciate at all – it went up in value.
If you sell the property for between $65,000 and $75,000, the amount of the selling price that exceeds $65,000 is the amount of depreciation that DID NOT really occur. Depreciation that did not really occur is said to be “recaptured” at the time of the sale. You must pay tax on it to make up for the deductions you took (or should have taken) previously.
Consider the following examples. In each case, an investment property is purchased for $100,000 and depreciated by $20,000 during the holding period – reducing the book value to $80,000 at the time of sale.
Case 1: The property is sold for $120,000 or $20,000 more than the original cost. The taxable gain on this sale (sale price minus book value) is $40,000. The first $20,000 of this gain is unrecaptured depreciation, and the rest is a capital gain.
Case 2: The property is sold for $92,000. The sale proceeds exceed the book value of $80,000, but do not exceed the original cost of the property. In this case, the $12,000 of gain on the sale is unrecaptured depreciation and there is no capital gain. The reader should note that although the property was sold for less than its original cost, there is no loss for tax purposes because the property was sold for more than its book value.
Case 3: The property is sold for $76,000 which is $4,000 less than its book value at the time of the sale. There is no unrecaptured depreciation and no capital gain. Instead, there is a capital loss of $4,000.
Currently, the depreciation recapture tax rate is 25%, while the maximum long-term capital gains tax rate is 15%.