Why Depreciation is the Best Tax Deduction
MATERIAL PARTICIPATION IS REQUIRED FOR INVESTOR TAX BREAKS
If you qualify as a real estate professional who spends at least
750 hours per year, or more than 50 percent of your working time
in qualified real estate work, and if you "materially participate"
in managing your investment property, there is no limit to the allowable
tax deductions from your 
properties
that can be subtracted from your other ordinary income. You can
still meet the material participation test and claim the unlimited
tax deduction as a real estate professional, even if you hire a
professional property manager to operate you property. However,
you must make the major decisions such as setting rents, approving
major expenses and qualifying new tenants. But day-to-day operating
details such as collecting rents, evicting deadbeat tenants and
unclogging drains can be delegated to others, such as your resident
manager or a professional property manager.
WHY DEPRECIATION IS THE BEST TAX DEDUCTION
Many potential real estate investors, and even current investment
property owners don't fully understand why depreciation is the best
real estate tax deduction of all. Uncle Sam requires property investors
to depreciate their investment properties such as rental houses,
apartments, warehouses, office buildings and shopping centers. Depreciation
is a "paper loss" required for estimated wear, tear and obsolescence.
However, land value is not depreciable. Residential income property
is depreciated over 27.5 years on a straight-line basis. Commercial
property is depreciated over 39 years. Personal property used in
operating the property, such as apartment appliances, is depreciated
over shorter periods, typically five to 10 years. Even automobiles
and trucks used in the investment operations can be depreciated
over their useful lives. There is also the new first-year 100 percent
deduction for up to $100,000 of business equipment purchased to
consider. Because depreciation is a non-cash expense deduction,
it reduces taxable income from the investment property. But it doesn't
require any cash outlay, as do property taxes, mortgage interest,
utilities, insurance and repairs. Although the depreciation expense
deduction often turns a positive cash flow property into a tax loss
for income tax purposes, the result is the investor's cash flow
from the rental income is said to be "tax sheltered." Because most
investment properties appreciate in market value each year, on paper
their "book value" is depreciating or declining annually. The bookkeeping
result is the book value declines while the market value usually
goes up.
THERE ARE TWO TESTS FOR PASSIVE ACTIVITY LOSS DEDUCATIONS
Real estate investments for tax purposes are said to be a "passive
activity." Unless you are a qualified real estate professional entitled
to the unlimited realty investment tax loss such as real estate
sales commissions, parttime real estate investors who earn less
than $100,000 annually can only claim up to $25,000 annual passive
activity deductions from their other ordinary income. To 
quality,
part-time investors must pass two tests. First, you must own at
least 10 percent of the investment property. The purpose of this
tax rule is to eliminate small real estate limited partners from
claiming loss deductions against their other ordinary income. Secondly,
you must "materially participate" in property management decisions,
as explained earlier. To illustrate, if you own a vacation condo
that is in a "rental pool" when you aren't using it, then that is
not considered material participation because you don't approve
each individual who uses your condo.
SAVE UNUSED PASSIVE ACTIVITY DEDUCTIONS FOR FUTURE USE
If you don't qualify to deduct all your investment property passive
activity tax losses against ordinary incomes, those undeducted losses
can be saved or suspended for use in future tax years or when the
property is sold. However, unused tax losses from investment properties
cannot be carried back to prior tax years to claim a tax refund.
IRS Notice 88-94 allows use of suspended passive activity tax losses
from realty investment assets to offset profits from the sale of
the property. The tax result is use of suspended property losses
on an aggregate basis, rather than property-by-property.
BEWARE OF RECAPTURED DEPRECIATION WHEN SELLING DEPRECIABLE REALTY
The 1997 Taxpayer Relief Act reduced the federal capital gains tax
rate to 20 percent. Then the maximum capital gains tax rate was
further reduced to 15 percent in 2003 for assets owned over 12 months.
But the special 25 percent depreciation "recaptured" tax rate remains
unchanged. "Recapture" means taxed when a property is sold. For
example, suppose you bought a small investment property for $300,000
and deducted $100,000 of depreciation during your ownership years.
That means your book value (also called "adjusted cost basis") declined
to $200,000. Then you sold for $450,000. Your capital gain is therefore
$250,000 ($450,000 minus $200,000). Of that $250,000 capital gain,
the $100,000 depreciation deducted will be "recaptured" and taxed
at the 25 percent special federal tax rate. The $150,000 remainder
of your capital gain will be taxed at the new 15 percent maximum
tax rate. However, a superb way to avoid paying the relatively high
25 percent federal recapture tax rate for depreciation deducted
is to make a tax-deferred exchange for another investment property,
as allowed by Internal Revenue Code 1031.
CONCLUSION
Real estate investment property offers many benefits, especially
tax shelter and probable appreciation in market value. Ownership
tax breaks are available during ownership and at the time of sale
or tax-deferred exchange. Full details are available from your tax
advisor.
