Can Real Estate Depreciation Offset Ordinary Income?

Real estate depreciation is a significant tax concept for property owners, accounting for the wear and tear or obsolescence of an investment property. This non-cash deduction reduces the taxable income generated from real estate assets, even if the property’s market value is increasing. It acknowledges the gradual loss of value in buildings and improvements, distinguishing this from land, which is not considered to depreciate. The primary purpose of depreciation is to spread the cost of an asset over its useful life, thereby reducing an owner’s annual tax liability.

Basics of Real Estate Depreciation

Real estate depreciation is a tax deduction allowing property owners to recover the cost of an investment property over a specified period. Land is not depreciable because it does not wear out or become obsolete.

The calculation of real estate depreciation begins with the property’s cost basis, which is the purchase price plus any capital improvements, minus the value of the land. For tax purposes, the Internal Revenue Service (IRS) assigns a “useful life” to different types of real property. Residential rental properties are generally depreciated over 27.5 years, while commercial properties are depreciated over 39 years.

The standard method for depreciating real property is the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, depreciation is calculated using a straight-line method, meaning the deduction is spread evenly over the property’s useful life. MACRS also allows a half-year of depreciation in the first year of ownership, regardless of when the property was placed in service.

Understanding Passive Activity Losses

The concept of passive activities and their associated loss limitations, known as Passive Activity Loss (PAL) rules, is central to understanding how real estate depreciation interacts with various income types. Generally, a passive activity is a trade or business in which the taxpayer does not materially participate. Rental activities, including rental real estate, are typically classified as passive activities by default, even if the owner is actively involved in management.

The core principle of PAL rules is that losses generated from passive activities can only be used to offset income from other passive activities. This means passive losses, such as those from real estate depreciation, cannot generally reduce “active” income (wages, salaries, business profits) or “portfolio” income (interest, dividends, capital gains). Any passive losses that exceed passive income in a given tax year are disallowed for current deduction.

These disallowed passive losses are not lost permanently; instead, they are carried forward to future tax years. These accumulated losses can then be used to offset passive income in those subsequent years. If a taxpayer disposes of their entire interest in a passive activity, any previously disallowed passive losses from that activity can generally be fully deducted in the year of disposition.

Circumstances Where Losses Can Offset Ordinary Income

While rental real estate activities are generally considered passive, preventing losses from offsetting ordinary income, specific exceptions allow for such deductions. These exceptions require certain levels of involvement or specific property classifications.

One significant exception is qualifying for Real Estate Professional Status (REPS). To meet this status, an individual must satisfy two primary tests: more than half of the personal services performed in all trades or businesses during the year must be in real property trades or businesses in which they materially participated, and they must perform more than 750 hours of services during the year in those real property trades or businesses.

If an individual qualifies as a real estate professional, all their rental real estate activities are no longer considered passive. This reclassification allows losses, including those from depreciation, to be deducted against ordinary income without limitation.

Another exception is the Active Participation Exception, which applies to non-real estate professionals. This allowance permits individuals to deduct up to $25,000 of losses from rental real estate activities against non-passive income. To qualify, the taxpayer must actively participate in the rental activity, which involves making management decisions or arranging for others to provide services. Additionally, the taxpayer must own at least 10% of the value of all interests in the activity.

This $25,000 deduction is subject to an Adjusted Gross Income (AGI) phase-out. The allowance begins to phase out when Modified Adjusted Gross Income (MAGI) exceeds $100,000, and it is completely eliminated when MAGI reaches $150,000. For every dollar of MAGI above $100,000, the deduction is reduced by 50 cents. For married individuals filing separately, the phase-out range is typically $50,000 to $75,000.

For short-term rental activities, specifically those where the average customer use is seven days or less, there is a potential to avoid passive activity limitations if the owner materially participates in the activity. Material participation is a more stringent standard than active participation and involves regular, continuous, and substantial involvement in the operation of the activity. The IRS provides seven tests for material participation, and meeting any one of them can reclassify the activity as non-passive. If material participation is met for these short-term rentals, losses can offset ordinary income.

Depreciation Recapture Considerations

While depreciation offers significant tax benefits during the ownership period of a real estate asset, it comes with a corresponding tax implication upon the sale of the property, known as depreciation recapture. When a depreciated property is sold for a gain, a portion of that gain attributable to prior depreciation deductions may be taxed at a different rate than regular capital gains.

The primary form of depreciation recapture for real property is “unrecaptured Section 1250 gain.” This applies to real estate that has been depreciated using the straight-line method, which is common for post-1986 real estate. The unrecaptured Section 1250 gain is taxed at a maximum rate of 25%. This rate is generally higher than the long-term capital gains rates for many taxpayers, which can range from 0% to 20%.

The amount subject to this recapture tax is the lesser of the gain on the sale or the total depreciation taken on the property. Any remaining gain above the original cost basis of the property, after accounting for depreciation recapture, is typically taxed at the standard long-term capital gains rates. The IRS assumes depreciation was taken, even if it wasn’t, for recapture purposes upon sale.