Can Rental Depreciation Offset Ordinary Income? (2024)

Real estate investors benefit from the tax shelter that real estate depreciation provides. Best of all, depreciation is a non-cash flow expense since it doesn’t impact an investor’s bank account. Some investors will have a large depreciation expense during a year, which can create an overall loss for their rental property. When that happens, can the loss be used to offset ordinary income?

How Does Rental Depreciation Work?

The IRS allows real estate investors to take an annual depreciation expense on their rental properties. How much depends on the type of property. For residential properties, the useful life is determined to be 27.5 years. For commercial properties, it’s 39 years.

To figure out the annual depreciation expense for a property, divide its value by the number of years. For example, a $400,000 residential property would take approximately $14,545 (400,000/27.5) per year in depreciation expense.

You can also divide the number of years by one to get the annual depreciation rate. Using a residential property again, 1/27.5 = 3.64%. Now multiply $400,000 by 3.64% to get $14,560, which is fairly close to the above result.

To see how depreciation affects rental income, we subtract the annual depreciation expense from income (after calculating net operating income). The following are simple examples to demonstrate how depreciation impacts taxable income.

Property 1

Income: $25,000

Depreciation: - $15,000

Taxable income: $10,000

A cost segregation analysis can speed up depreciation so that more is taken in earlier years. This can be more than enough to push the property into a paper loss.

Income: $25,000

Depreciation: - $35,000

Taxable income: $-10,000

A loss from one property can offset income on another property. This pairing can occur because both have a passive income/loss status, which we’ll discuss later.

Property 2

Income: $15,000

Depreciation: -$5,000

= $10,000

Using Property 1’s loss to offset income on Property 2 results in a net $0 of income for both properties.

Rental Depreciation and Ordinary Income

What if Property 2 shows a $5,000 loss for a total loss across both properties of $15,000? In this case, we’ve already used our rental property losses to offset all rental property income. But we still have $15,000 of rental property losses available. Can that be used to offset ordinary income, such as wage income?

Imagine a real estate investor making $100,000 from their full-time job. Applying the $15,000 rental property loss to their income would bring it down to $85,000. If only it were that simple.

Rental property income and losses are considered passive. Wage income is earned income and falls within the category of ordinary income. The IRS does not allow us to mix passive losses with ordinary income. So, it is not possible to offset ordinary income with rental property losses, whether those losses are due to depreciation or operating expenses.

But there may be an alternative route to offset ordinary income with rental property losses.

Qualifying as a Real Estate Professional

Qualifying as a real estate (RE) professional can offset ordinary income. However, achieving this status is not easy. Two criteria must be met to qualify:

• Work at least 750 hours per year in real estate-related activities.
• Any other job you have cannot exceed your hours worked in real estate.

750 hours per year comes out to around 14.5 hours per week. As you can see, this leaves out any other full-time job. So our investor making $100,000 at his full-time job would not be able to qualify as an RE professional.

All is not lost, however. A married investor filing jointly has options. The spouse can qualify as an RE professional. In this case, property losses can be applied to the husband’s wages for an overall reduction of income.

What are real estate-related activities? These include driving around looking at properties, managing real estate, and researching properties. It’s important to keep track of all the time spent on these activities.

Anyone considering qualifying as an RE professional must keep real-time, meticulous records of their activities. A real estate tax professional can help determine if this is the best route.

However, with the RE professional status, investors who want to offset ordinary income using rental property depreciation are simply out of luck.