Barred From Using Depreciation Against Your Ordinary Income? Consider This

Actually, there are two groups who might wanna consider this strategy. If your ordinary income (job) exceeds $150,000 annually, you can’t make use of any depreciation against that income whatsoever. Even those making $100,000 a year or less can use this approach if they find themselves with significant amounts of unused depreciation every year. The Internal Revenue Code puts a ceiling of $25,000 in annual depreciation that may be used to reduce your ordinary income. Many real estate investors have far more depreciation available than that figure.

If for whatever reason you find yourself in a ‘capital growth’ mode while the happy recipient of decent cash flow, consider periodically applying the lion’s share of it to your loan balance(s). If your interest rate is say, 6% or so, you’re beatin’ the bank’s alternative comin’ and goin’. Not only that, but the cash flow was sheltered from the get go. Every dollar of principal paid off is a dollar on which you’re not gonna pay 6%. At the end of the year you’re not taxed on it either. It’s not even a taxable event at that point. You win.

But wait, there’s more.

Because you have accumulated so much unused depreciation (tax shelter), when it’s time to sell and move up, you’ll have a good news/better news ending. The good news is you’ve created a whole bunch of extra sales proceeds due to having applied so much cash flow over the past X number of years to your loan balance. The better news is, that extra cash can be mostly if not entirely sheltered by all the unused depreciation you’ll now pull off the shelf.

Here’s an example of how it would work.

You bought a $400,000 income property several years ago. It hasn’t appreciated much, just a little in fact, but it’s rents have increased to the point it’s been yielding roughly $8,000 a year in cash flow. Let’s say for five years you apply $6,000/yr of your cash flow against the principal. Here’s your loan picture at the end of those five years.

First, we’ll pick a starting balance. We’ll say the loan began at $320,000 seven years ago. That means your current balance is about $286,850. Five years from now that balance will have dropped to roughly $253,050.

If the payments were increased by the above suggested $6,000 — paid monthly in $500 principal payments — here’s what would happen. Your balance would’ve dropped, in the same five years, to around $217,100. That’s a gain in equity just short of $40,000 — using cash flow you didn’t need in the first place.

If you’d kept the $6,000 a year for those five years, you’d have made 2-4% before taxes, and before any potential inflation. In other words, this strategy allowed you to earn 6% interest on your cash flow, and you will, more likely than not, never pay taxes on it. In better times, which we will live to enjoy again, that can mean the ability to acquire more property than if you hadn’t executed the strategy.

Anywho, something for you to consider.

Consider starting a conversation, OK? I’m at 619 889-7100 OR use the Contact BawldGuy button up top and sent me a note. Have a good one.

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About BawldGuy

I'm second generation real estate, first licensed in fall of 1969. Having been mentored by several iconic brokers, I'm also CCIM trained, having completed all 200 hours back in 1980. Have successfully executed well over 200 tax deferred exchanges, many of which have been multi-state in nature. Strong points are analysis and the creation and real world application of Purposeful Plans employing several strategies synergistically. The idea is to arrive at retirement with the most after tax income possible, backed by the largest net worth.

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23 thoughts on “Barred From Using Depreciation Against Your Ordinary Income? Consider This

  1. Joshua

    *raises hand with eager anticipation of being called on*

    Maybe I’ve missed this in a previous post.. but how long can depreciation NOT be used? For example, if I purchase an investment property today and then file taxes for the next 5 years (still owning that property) and never claim my depreciation, what happens? If I don’t use it I lose it? How long can I go before I could reclaim all of it over time?

    Maybe I’m not asking the question right but hopefully you get my intention.

    Reply
  2. BawldGuy Post author

    Josh — It depends, why didn’t you use it? Most folks use what’s allowed, then it sits until they find a use for it. Those who make too much money at work. ($150K+) can’t use any of it against their job income.

    Depreciation is first applied (by rule) against the property’s income, then any excess against your job income, if allowed. If there’s ‘leftovers’, it remains until there’s a use allowed by the code. Typically it would be when you sell a property, incurring a cap gain. It’s at that point you might consider dusting off that depreciation and applying it to offset the gain and depreciation ‘recapture’ if applicable.

    If you have some now, use it against your income. Otherwise you’re paying taxes you don’t need to pay.

    Reply
  3. Joshua

    You answer makes sense and helped me clarify my question as follows: If I make the typical salary here in Iowa (+/- $40k) and owned a property that appreciated well wouldn’t it be prudent of me to save that depreciation for the sale rather then use the amounts year by year towards my salary considering income (for example) is only $100 / month?

    Reply
  4. Jeff Brown

    I’ll have to check with my resident tax code expert, but if memory serves, depreciation is like interest. The IRS is crazy when it comes to interest rates. Let’s say you were in financial trouble and sold your property to me, carrying back some of the financing. I made you charge just 4% interest on the note. The IRS would force you to pay taxes on that interest as if it was (I think) 7%! Why? They call the the ‘imputed rate’. THEY decide what minimum rate is ‘acceptable’.

    Seriously, I’m not makin’ this up. :)

    I think, but again will hafta check, that depreciation must be applied to your prop’s cash flow. Whether or not it must be applied to your job income is questionable. I’ll find out for ya.

    Reply
  5. Joshua

    Ahh, the bliss and warm fuzzy feeling we all get whenever someone speaks of the IRS. ;(

    Thanks for looking into it. Sounds like a tough issue and one that must be dealt with in kid gloves so as to avoid a nice love letter from the IRS down the road.

    Reply
  6. Doug Gould

    It’s not a question of use it or not. The IRS says that if you are allowed to use it you are deemed to have used it, even if you did not. So it is as they say, “use it or lose it”. The dilema posed is for excess depreciation that you are unable to use either due to income or reaching the $25,000 limit.

    Reply
  7. BawldGuy Post author

    Doug — As I’ve understood it to be since forever, but I’m always wary of making declarations if I haven’t had to address an issue for awhile. Thanks

    Also, there’s really no dilemma with excess depreciation. It can be used to offset long term cap gains, along with other losses. It’s a stellar tool to have available.

    Please, don’t be a stranger, OK?

    Reply
  8. Troy

    New to REI… and anxious to learn.

    Is the $150,000 income limit for recognizing passive losses against ordinary income based on “married filing jointly” or “single”, or is it more complicated than that…?

    Also regarding cost basis when converting from primary residence to rental. Especially in these times, what was once paid for a house may not reflect it’s worth when converted to service as a rental. Can the original cost of purchase be used to form the cost basis? Or must we use market value at the time of conversion?

    Reply
  9. BawldGuy Post author

    Troy — Amazing I haven’t had to deal with that question for ages. Pretty sure it’s married, filing jointly. But just pretty sure.

    The house will be valued as of the day you ‘put in in service’ as a rental. NOT what you paid for it.

    Reply
  10. doug gould

    It is actually the lesser of the cost (what you paid) or present value. In the past the basis used for calculating depreciation was usually the original cost but since values have been falling you may very well have current values less than original cost.

    Reply
  11. BawldGuy Post author

    Hey Doug — The last time I checked, a while ago, the code’s language was relatively unambiguous. Taxpayer was to use the market value the day the residence went into service as a rental.

    I’ll double check.

    Reply
  12. BawldGuy Post author

    Doug — OK, now you’ve done it. :) Gonna hafta get serious here and see if there’s been a change. Since about forever it’s been the market value at the time of conversion. Always willing to be wrong.

    I’ll get back to ya.

    Reply
  13. Dan Priem

    If I earn more than 150K in my job and cannot use depreciation, then sell the rental property that was subject to the depreciation, do I have to pay tax on recaptured depreciation even if I didn’t use it? Or are you saying I can “bank” the unused depreciation and reduce the capital gains on the future sale of the rental?

    Reply
  14. BawldGuy Post author

    Welcome Dan — Unused depreciation can be used to offset a capital gain. I’ve executed that strategy many times over the years, for clients.

    Reply
  15. David

    I don’t see how. The properties I sold were rented, but there was little net income to be offset by depreciation. I am doing my taxes now and all the carryover does is offset the recaptured depreciation, which was I was not able use to offset ordinary income. In addition, it seems that IRS now taxes recaptured depreciation at 25% instead of the 15% capital gains rate. Since the gain was almost the same as the recaptured depreciation, I am now doubly penalized since I could not use the depreciation against regular income and now have to pay 10% for the privilege of not using it.

    Any insights on this would be appreciated

    Reply
  16. BawldGuy Post author

    Welcome David — As the post says, the investor must have enough unused depreciation to cover everything. And yes, recaptured depreciation is often taxed at 24% — much higher than capital gains.

    Most who make use of the offset successfully, own multiple properties which, when combined, generate enough extra depreciation over time to allow this strategy.

    Reply
  17. David

    Thank you for your answer. It does not seem there is anyway to at least only pay the normal capital gains rather than the higher rate unless you are classified as a real estate professional. Any suggestions would be appreciated.

    Reply
  18. BawldGuy Post author

    Being a RE pro in the eyes of the IRS is a double edged sword. If you’re a big wage earner, and/or have lots of cash flow properties, it gets used up quickly each year. On the other hand, if you’re trying to establish a basket of unused depreciation for future use, acquiring multiple properties with very little cash flow, while making over $150K at work, and NOT being a RE pro is the formula.

    Make sense?

    Reply
  19. Mike

    I have a question about using extra cash flow for paying down principle in your example. Does additional principal payments made by a property’s cash flow reduce the cash flow basis on which depreciation must be applied? I’m in the north of 150 AGI group and am intrigued by the idea of accumulating a large cap gain offset as I don’t need to extract all cash flow to survive.

    I recently absorbed your presentation done at the BiggerPockets summit and the content got me thinking.

    Reply
  20. jeffrey gordon

    Ok, now as a former bean counter, I have read through the post and comments and I am still a little unclear about the concept of unused depreciation. If we assume a top income bracket of 35% then any depreciation dollars used will reduce taxes by 35% up to the Ordinary Income threshold of $150k. At the time of sale and capital gain, those accumulated depreciation expenses will be recaptured at a 25% which is a 10% advantage to the property owner besides having the money to use between the deduction period and the sale. So in effect anyone with a marginal federal tax bracket above 25% will be better off taking the depreciation deduction–we will ignore state taxes for now.

    maybe I am confused but one of the comments seemed to imply that even if you can not use or do not take the depreciation deduction you will still have to “recapture” it at 25%? That doesn’t make any sense, if you did not reduce the basis with the deduction and gain some benefit, how could you pay 25% tax on the “recapture” of it?

    So lets say we are 10 years after buying the building and we have $60,000 in unused straight line 27.5 year depreciation accumulated.
    and we now sell it for $350,000 and offset the sales price with the $60k of accumulated/deferred deprecation and end up with approx. $290k less $255,000 acquistion cost basis or $35,000 capital gain at current 15% tax rate or $5,200 in capital gain taxes. Do we then pay 25% or $15,000 in recapture tax on the accumulated depreciation we never took till the sale on the $60,000 in accumulated deferred. depreciation? this would not make any sense, better off to forget the depreciation unless your tax rate is higher than 25% for capital gains or NOI.

    Reply
    1. BawldGuy Post author

      I see where you’re coming from, Jeff. If the depreciation is on the shelf gathering dust, the bottom line is that it will eliminate much if not all of the investor’s gain and/or recapture tax. Payin’ nothin’ beats payin’ somethin’ every time it’s tried. Make sense? Did I not get your point?

      Reply
    2. Don Reedy

      Jeff, I ran into this question a few years ago. During a discussion with a Real Estate Tax attorney she indicated what Jeff has said….(paraphrasing) “We don’t care if you took it or not, your SHOULD have taken it, and we’re taxing you on it.” This by the IRS as to recapture.

      Oh I argued that it “didn’t make sense”, but in the end, it’s actually true. The IRS rules are clear: You CAN take depreciation. You SHOULD take depreciation. If you don’t…bank error in our favor. We’re taking you anyway.

      I think I talked with Jeff a long time ago about simply putting this bit of information out to the public…yes, those investors who think they know their stuff, but really are hobbyists, and see if some good might be able to be done. If you haven’t taken depreciation….start.

      Reply

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