Can Depreciation Offset Your W2 Income?

Depreciation can reduce your taxable income, but offsetting W2 income involves understanding tax rules. Depreciation is a tax deduction, particularly for owners of income-generating assets like real estate. W2 income represents earnings from employment where taxes are withheld. Using depreciation to lower W2 income depends on how the Internal Revenue Service (IRS) classifies the activity generating the depreciation.

Understanding Depreciation and Income Types

Depreciation is an accounting method allowing businesses and real estate investors to recover asset costs over their useful life. Assets like buildings and equipment lose value over time. This non-cash expense reduces taxable income. Residential rental properties typically depreciate over 27.5 years, commercial over 39 years. A portion of the property’s value, excluding land, can be deducted annually.

W2 income is wages and other compensation received as an employee. This active income is earned through direct involvement in a trade or business. The IRS categorizes income and losses into active and passive types. Passive income comes from rental activities or businesses without material participation. Passive activity losses (PALs) dictate how losses, including depreciation, can be used.

Passive Activity Loss Rules

IRS passive activity loss (PAL) rules limit using passive losses to offset earned income. Their purpose is to prevent using paper losses from inactive investments to reduce tax liability on active income like wages. These rules are outlined in IRS Publication 925.

If an activity is passive, losses (including depreciation) can generally only offset other passive income. Excess passive losses are not immediately deductible against non-passive income, like W2 wages. Instead, disallowed passive losses are suspended and carried forward indefinitely. They can offset future passive income or be fully deducted when the taxpayer disposes of the activity. For most rental activities, the IRS automatically classifies them as passive, unless specific exceptions apply.

Strategies for Utilizing Depreciation Against W2 Income

While passive losses generally cannot offset W2 income, IRS-recognized strategies allow for this. These involve reclassifying rental activity as non-passive or meeting participation thresholds. Each strategy has specific requirements.

Active Participation Exception

The “active participation” allowance is a common exception for rental real estate activities. If you or your spouse actively participate, you may deduct up to $25,000 of passive losses against non-passive income, including W2 wages. Active participation is less stringent than material participation, requiring no specific hours. To qualify, you must own at least 10% of the property and be involved in management decisions, such as approving tenants or authorizing repairs.

This $25,000 allowance is subject to a Modified Adjusted Gross Income (MAGI) phase-out. It phases out when MAGI exceeds $100,000, reducing by 50 cents for every dollar above this threshold, and is eliminated at $150,000 MAGI. Excess losses due to the phase-out are carried forward.

Real Estate Professional Status

Qualifying as a Real Estate Professional (REP) overcomes passive activity loss limitations. This status allows rental real estate activities to be non-passive, enabling full deduction of losses (including depreciation) against all income, including W2 wages, without income limitations. REP status requires meeting two stringent tests during the tax year, as outlined in IRS Publication 925.

First, over half your personal services in all trades must be in real property trades or businesses where you materially participate. Second, you must perform over 750 hours in real property trades or businesses where you materially participate. Real property trades include development, construction, rental, management, or brokering. Material participation means significant, continuous involvement, often met by over 500 hours in an activity annually. Document all hours spent on qualifying activities, as the IRS scrutinizes REP status claims.

Short-Term Rental (STR) Reclassification

Short-term rental (STR) owners can reclassify their activity as non-passive to offset W2 income. If the average customer use is seven days or less, it may not be a “rental activity” under passive rules. This transforms the STR into a trade or business.

Once reclassified, you must satisfy an IRS material participation test for trades or businesses. The most common test is over 500 hours of participation annually. Other tests include substantially all participation, or over 100 hours with no one else participating more. If material participation is met, STR losses (including depreciation) can offset non-passive income like W2 wages. Maintain detailed records of time spent managing the STR to substantiate material participation.

Accelerating Depreciation

Beyond exceptions, strategies can accelerate depreciation, creating larger “paper losses” more valuable if an exception applies. These accelerated deductions amplify tax benefits when used to offset W2 income.

A cost segregation study identifies and reclassifies building components for shorter depreciation periods than the standard 27.5 or 39 years. Instead of depreciating the entire building, a study reclassifies components like electrical systems, plumbing, or carpeting to shorter recovery periods (e.g., 5, 7, or 15 years). This accelerates depreciation, leading to larger early write-offs.

Bonus depreciation allows businesses to deduct a large percentage of qualifying property cost in the first year, rather than over many years. While the Tax Cuts and Jobs Act (TCJA) initially allowed 100% bonus depreciation (2017-2023), the percentage is phasing down: 60% for 2024, 40% for 2025, with further reductions planned. This immediate deduction applies to new and used tangible personal property with a recovery period of 20 years or less, including components from a cost segregation study. Combining cost segregation with bonus depreciation generates substantial upfront deductions, which, if a passive activity exception is met, can significantly reduce W2 income.

Tax Implications of Depreciation

While depreciation offers tax benefits by reducing current taxable income, it carries future tax implications, primarily through depreciation recapture. Depreciation recapture is an IRS rule to reclaim tax benefits when a depreciated asset is sold at a gain. If you sell a property for more than its adjusted basis (original cost minus accumulated depreciation), the IRS “recaptures” previously claimed depreciation.

For real estate, this recapture is generally taxed at a maximum 25% rate on the gain attributable to depreciation, known as “unrecaptured Section 1250 gain.” This rate is typically higher than long-term capital gains rates. Any gain exceeding the recaptured depreciation is taxed at applicable capital gains rates. While depreciation provides an annual tax shield, it can lead to a tax liability upon asset sale, effectively delaying rather than eliminating tax on that gain portion. Consider this potential future tax when evaluating the financial impact of depreciation.