Ordinary vs Capital Losses

[Steve Sanderson]

I'm currently reading The Book on Tax Strategies for the Savvy Real Estate Investor and reached the section about real estate losses. They mention that real estate losses are often times mistaken as a capital loss. In reality they are considered to be an ordinary loss and can be used to offset W-2 income. Am I understanding that correctly? I had always assumed that real estate losses could only be used to offset passive income (current and/or future) and could NOT offset W-2 income. Anyone have any input on this?

[Steven Hamilton II]

This is where it depends upon if income is over 150k at which point the 25k special allowance has been phased out. The only exception is year of sale and for real estate professionals.

[Ashish Acharya]

@Steve Sanderson, 

Good question, but this is going to get. Let me see if I can explain without getting technical.

1) Trade or business asset are never capital asset. They are 1231 asset.  You house is capital asset, not rental or flip houses. So there is never capital loss. 

2) Limitation you are talking about is passive activity limitation. Real estate rental losses are always passive and can go against your passive income unless you are RE pro.  There is an expection for 25k if you are below 100k AGI up to 150k AGI. 

3) when you dispose the RE rental asset, the loss is section 1231 loss, not capital loss. 1231 loss are ordinary loss. 

[Basit Siddiqi]

@Steve Sanderson

What some tax practioners, including taxpayers who do their own return, make the mistake is they classify the loss from sale of a rental asset as a capital loss instead of an ordinary loss.

The difference is capital losses are limited to $3,000 per year with the rest carried forward indefinitely.
Ordinary losses can be fully utilized in year of disposition.

Imagine a taxpayer who is $250,000 of W-2 income and the difference in taxable income when classifying a $100,000 loss from a rental as capital loss vs ordinary loss

Capital Loss = $247,000 of taxable income(not accounting for other items/itemized or standard deduction)
Ordinary loss = $150,000 of taxable income(not accounting for other items/itemized or standard deduction)

It is a big difference.