Depreciation can not be deducted?

Question

Hi BP community! I just talked to a financial planner/CPA and she said that depreciation of a rental property can not be written off as a deduction if your household income exceeds 150K. I could not find any proof of that info. Is it true? Could you please point me to more info on that? Thanks!

Brandon Hall · Answer

Account Closed

You must always take depreciation regardless of what your income level is. Your CPA is referring to deducting losses generated by real estate activities. He/she is also assuming that you are an "active" participant in your RE activities. As an active participant, once your income exceeds $150k, you cannot deduct any amount of tax loss generate by RE activities against your ordinary income. Any loss that you are not able to deduct is "excess" and is carried forward until it can offset passive income or you sell your property.

I'll highlight the three activity levels below. It should be noted (as someone mentioned above) that people who can be classified as an RE professional will reap the benefits.

The first level of participation is simply "passive" participation. If you do not "materially participate" in the RE activity, then you are not an active participant and carried forward passive losses can only off-set passive income.

The second level of participation is "active" participation. If you are an active participant, then you receive a special allowance up to $25,000 in which you can deduct passive losses against your ordinary income. You are an active participant in a rental real estate activity if you owned at least 10% of the rental property and you made management decisions or arranged for others to provide services. "Management Decisions" consist of approving of new tenants, deciding on lease terms, approving expenditures, hiring contractors, etc.

Limitations exist and center around your Modified Adjusted Gross Income (MAGI), which is reported on your Form 1040. If your MAGI is high enough, it may disqualify you for the special allowance. If you are single or married filing jointly, you may use the full $25,000 allowance if your MAGI is $100k or less, meaning if you have a $25,000 rental loss for an RE activity in which you actively participated in, you can use the entire loss to offset your ordinary income. The allowance begins to phase out by fifty cents on the dollar once your MAGI goes over $100k and is completely eliminated once your MAGI hits $150k.

If you were not an active participant in the activity in prior years, but this year the activity becomes active because you materially participate, then suspended passive losses can be used to offset income from the new active activity, but it must be the same activity as when it was a passive activity. And again, if your MAGI is above $150k, you won't be able to deduct the losses anyway.

The third level of participation is being classified as a real estate professional. If you are classified as a real estate professional, all real estate losses can be used to off-set your ordinary income. To qualify, 51% of the personal services you performed in all trades or businesses during the tax year must be performed in real property trades or businesses in which you materially participated AND you performed more than 750 hours of services during the tax year in real property trades or business in which you materially participated.

However, if you are working in the real estate field (i.e. as a broker) and working for someone else (i.e. you are an employee), you do not get to count these hours or services toward the two criteria stated above unless you own at least 5% equity of the business you work for.

Hopefully reading this will save you from having to sift through the IRS code.

Matt Devincenzo · Answer

To add on to what @Drew Vukov said, you "lose" the ability to deduct depreciation against your W-2 income once that is over 150K (the phase out starts at 100K). That being said you don't actually "lose" the depreciation deduction, the unused depreciation is carried over. It continues to be carried over until it can be used. Say when you sell the property you have a 100K capital gain, and you also have 50K of carried over depreciation. you would be able to use that depreciation to reduce the taxable gain.

Here is the IRS Guide that goes through the calculation. Open it up and search for "phase out" that will give you an idea of what it is that they're talking about and how it is calculated. There are several different pubs that you (your CPA/EA really) needs to be familiar with to properly take all your deductions. This one deals with the passive activity limits, of which depreciation is one. There is another that goes into the rental income deductions and depreciation conventions/schedules. They are used in conjunction to actually perform the calculations and then claim your deductions.

Dave Toelkes · Answer

Account Closed

Depreciation is always deductible for a rental property.  A high enough income will phase out the net passive loss allowance for a rental activity, but that is not linked to depreciation at all. Time to get another CPA.

Bill Exeter · Answer

The other point to note is that if you do not depreciate the property you will be hurting yourself in the future.  You will be required to compute and pay depreciation recapture taxes when you ultimately sell (and not 1031 Exchange) at the end (assuming that you are not a swap 'til you drop kinda investor) whether you have depreciated the property or not.  So you always should depreciate the property whether you can take advantage of the deduction today or not.

Dave Toelkes · Answer

Just to clarify what David Krulac said.  Depreciation is always allowed and is always used to offset rental income.  In the event you have NET rental losses that cannot be used, then the excess loss (not just the depreciation) is carried forward to offset future rental income or used in full when the property is sold.

David Krulac · Answer

One other thing to add, presuming you're not a real estate professional, and earn more than $150,000, any excess depreciation that was not allowed is carried forward and offsets capital gains when you sell the property.  So you don't lose the depreciation deduction, its just deferred.

Anna Stolpe · Answer

Thank you all for your answers it makes much more sense now. A special "thank you" to @Brandon Hall for taking the time to give me a very detailed response. I did save me a lot of time.

Adam Pasch · Answer

Thanks to everyone who contributed on this thread. Very informative and now I know what I need to talk to my CPA about.

Adam

James Harper · Answer

Thank you gentlemen, I needed that clarification as I was getting stuck on the part that because in a non-IRA environment that we always have to depreciate the property, regardless if there is a tax benefit, that it might cross over into the IRA environment.

Jim

Depreciation can not be deducted?

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