The Untold Secret of Real Estate Depreciation

Flipping houses gets the attention. Depreciation, and the rules that can trap it, is the part of real estate investing that rarely does.

I am constantly amazed by the number of times I scroll through social media feeds and see someone talking about how they flipped a property, used the BRRRR method or use their vacation property as a short-term rental. It seems like everyone who isn’t involved in real estate is missing out on the real estate bonanza. Heck, if the real estate market can collapse between 2008 and 2011 but rebound to new heights a decade later, it makes a strong case for becoming a real estate investor. In fact, when you add up the benefits associated with real estate investing (cash flow, write-offs, depreciation and capital appreciation), I am left to wonder why everyone isn’t a real estate investor. That is, until I discovered an untold secret during my investigation into purchasing multifamily units. Once I learned this secret, I realized why so many are at a severe disadvantage when investing in real estate. What’s the disadvantage, you ask? This article is going to pull back the curtain on one of the largest untold secrets of real estate investing: trapped depreciation and losses.

Real estate investing 101

To understand the importance of real estate losses, we need to take a brief step back and outline the purpose of real estate investing. If you are well versed in real estate investing, you can skip to the next section. For those who are newer to the concept, the following is an overview of investing in real estate.

Real estate investing is not a new concept. It has been around for hundreds of years. Granted, it has taken on newer forms over time, but the concept of owning property and leasing or renting it to another is not new.

I remember a time in my teens watching Carleton Sheets on late-night TV selling the dream of owning real estate. The dream of owning multiple properties that other people would pay off while also paying you a monthly income sounded like a no-brainer. Of course, as with everything in life, nothing is ever as simple as it appears.

Assuming you could find a property at an affordable price, a contractor who could complete the necessary repairs in a timely fashion, the down payment to purchase and renovate the home, and a renter who would pay the rent on time, the dream of being a real estate investor could be in your future. If everything worked in your favor, you could rinse and repeat this process over and over, allowing you to build a real estate portfolio that, in some cases, could allow you to become financially independent before most of your peers.

Of course, as with anything, there are drawbacks to real estate investing. For example, it isn’t feasible to think every property you purchase will be free of damage. It isn’t realistic to believe every tenant will be the perfect tenant (pay on time, never complain or live in the property for the entire time you own it). Furthermore, it is not practical to think items in the property will last longer than projected. It is due to these drawbacks that many investors opt not to invest in real estate. They would rather invest in other areas than be a landlord.

But IF you are the lucky one who finds a property with a great tenant who takes care of your property for the duration of the time they live there, then you may have hit the jackpot. In situations like this, the free cash flow (total rental income minus all expenses) could offer some financial support in other areas of your life. In fact, if you were able to turn your real estate hobby into a full-time business, you could enjoy an early retirement, depending on the number of properties in your real estate portfolio. Sounds pretty amazing, right?

The untold secret

Under ideal circumstances real estate investing sounds pretty amazing. In fact, if I didn’t love what I do for a living, I would absolutely be a full-time real estate investor. Unfortunately, it is for that reason that I will never be able to receive one of the largest benefits associated with real estate investing, which in many cases makes real estate investing quite lucrative.

Earlier I listed a few of the benefits associated with investing in real estate. However, one benefit I left out relates to net losses from depreciation. I left it out because it isn’t something everyone benefits from while they own a property. But before we get into that, let me explain what depreciation is and how you could benefit from it.

In the simplest terms, depreciation is the deduction, or reduction, of the cost associated with the purchase and renovation of real estate. Essentially, it is a paper loss. To incentivize people to invest in real estate, the IRS allows investors to depreciate, or deduct, the value of their real estate over a period of time. This deduction can lower the tax impact of renting the property to someone else. The best part: since depreciation is a paper loss, rather than an actual loss from money you spent each year, your total losses each year can exceed your rental income, allowing you to apply excess losses to other income (investment income, wages, profit share distributions and more).

For example, if you purchase a rental property for $100,000, assuming a normal depreciation schedule, you are allowed to divide $100,000 by 27.5 years and deduct $3,636 of the home’s cost basis per year. Add this paper loss to the $10,000 in other expenses associated with owning or maintaining the rental property that year, and your $12,000 of rental income is reduced. Heck, it is not just reduced: the $12,000 of taxable income is zeroed out AND you have a loss of $1,636 to carry over. Sounds reasonable, right?

In situations where your rental income far exceeds your allowable deductible losses and expenses, you may need to pay income taxes on the excess income. Alternatively, if your expenses exceed your rental income, you are not typically required to pay taxes on the income received. This is where depreciation can impact your taxes positively, or negatively. Let me explain.

At different times throughout this article I mentioned the value of being a full-time real estate investor. I did this because this is the ONLY way to deduct ALL of your real estate losses each year. Yes, you read that correctly: this is the ONLY way to deduct ALL of your real estate losses each year.

“But wait, Jon, I have been deducting all of my losses, and I have been a part-time real estate investor for years!”

Okay, you caught me. You do not have to be a full-time real estate investor. You can be a part-time real estate investor, but frankly you’ll probably end up burning out based on the 50/750 rule and the passive activity loss rule. Never heard of those? Let me explain.

The 50/750 rule

This rule was created by the IRS to draw a bright line in the sand between real estate professionals and everyone else. According to IRS Publication 527, to qualify as a real estate professional you must meet the following criteria:

• More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
• You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.

This means you have to spend at least 50% of your time materially participating in real property trades or businesses; otherwise you ARE NOT deemed a real estate professional and are not afforded all the perks of one. In other words, if you work a “normal 40-hour work week” (and let’s be honest, I can’t remember the last time I worked a 40-hour week), then you have to ALSO work another 41 hours that same week in real property trades or businesses. So unless you are already retired, are a workaholic or are independently wealthy and can devote most of your time to real property trades, you fail the first qualification. If you fail this first test and still deducted depreciation, along with all other rental expenses, you could be in hot water.

The second qualification is a little easier to meet, as it states you need to spend 750 hours a year of your time performing services related to the property you are materially participating in. In other words, if you own a property, you need to spend AT LEAST 750 hours per year dedicated to running and managing that property.

If you have multiple properties, you can combine the work across all of them to reach the 750 hours, instead of needing to perform 750 hours per year per property. But what does materially participating in a property mean?

According to the IRS, “you materially participated in an activity for the tax year if you were involved in its operations on a regular, continuous, and substantial basis during the year.” You can read about this in greater detail in IRS Publication 925.

The CliffsNotes version of Pub. 925 basically states you need to actively market and manage the property. This would involve things like, but not limited to, advertising the property, fielding calls from tenants, and either doing repairs yourself or hiring others to complete repairs. You are NOT considered to be materially participating in a property if you hire a management company to market the property and field calls from tenants.

But wait, there’s hope!

If you DO NOT spend 50% of your time working in real estate but DO materially participate in real estate endeavors, what happens to the losses your properties accrue, especially if your losses are in EXCESS of your rental income? Have no fear, there is a small loophole.

The passive activity loss rule

There is an exception to the 50/750 rule, but the windfall isn’t great. The IRS states, “if you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.”

But remember, to be considered actively participating in rental real estate, you must perform the duties outlined in Pub. 527:

“You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.”

So the good news is that even when you do not qualify as a real estate professional, you can still deduct a small portion of passive losses against active income (such as wages). Unfortunately, any losses in EXCESS of your $25,000 allowance are trapped until the end of time. Well, not really. They are trapped for as long as you own the property. Once you sell the property, you can unlock those trapped losses.

The bottom line

What’s the bottom line, you ask? I’ll give it to you straight. If you do not spend 50.1% of your working hours on real estate (which would be easy to prove for any employee or full-time non-real estate entrepreneur) AND you do not spend 750 hours materially participating in all of your properties, then you CANNOT DEDUCT ALL of your losses. Your passive losses will be limited to your passive income, with the exception of $25,000, assuming you actively participate in your rental real estate.

Since depreciation can be such a large expense, depending on your real estate portfolio, you may find your depreciation trapped in the property until you sell it. Therefore, if you find yourself scrolling through a social media feed, or overhear someone talking about not paying taxes because they are a real estate investor, DO NOT fall victim to FOMO (fear of missing out). The benefits afforded to a full-time real estate investor are different from the benefits afforded to everyone else.