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Updated over 9 years ago on . Most recent reply

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91
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Joel Bowen
  • Portland, OR
19
Votes |
91
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Understanding how depreciation counts as negative income?

Joel Bowen
  • Portland, OR
Posted

Hi guys, the following quote is from this BP article:

 https://www.biggerpockets.com/renewsblog/2014/10/2...

Could somebody please help me understand this concept by giving a real life/hypothetical situation that makes more sense to me. Thanks

"The IRS allows you to write off the value of any property over 27.5 years. This depreciation counts as negative income, but it’s only negative on paper since the costs of keeping a property in good condition can be paid for out of the rental income.

Thus, the depreciation “losses” wipe out the positive cash flow from the property and remove any tax obligation. Unfortunately, due to the Tax Reform Act of 1986, only active investors can take advantage of this."

Most Popular Reply

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254
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273
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Daniel Chang
  • Professional
  • Riverside, CA
273
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254
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Daniel Chang
  • Professional
  • Riverside, CA
Replied

Depreciation is a "non cash expense".  If you have $10,000 in rental income, and $8000 in actual "cash" expenses (maintenance, marketing, taxes, insurance, etc), you would have $2000 of net profit/cashflow that normally you would pay taxes on.  However if you then add on non-cash expense of depreciation, that may reduce the net profit to less than zero so you have a net loss.  Add on $2500 of annual depreciation, you net income would be $-500.  So you won't owe any taxes despite having a cash flow of $2000.  The quote is slightly wrong.  ANY investor can take advantage of this.  

What it's alluding to whether you can then use that $-500 and offset that against your earned income (ie a job that you work).   Back in the day, people who earned a lot of income buy real estate as "tax shelters" to use the depreciation to offset their earned income.  The Tax Reform Act 1986 did away with this.  Essentially IRS says real estate buy/hold is passive income and generally passive losses can only be deducted against passive income.  There are some exceptions to the rule if you "actively participate" or "materially participate" in the real estate investment.  It's pretty easy to fall under the "active participation" rules.  

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