I was presented with a problem from a friend which we have talked
through and the decision was rent to own instead of selling at a loss.
I went through schedule C and E with him, as well as the 1040 and had
some questions which are still "not answered", even though I believe
some things to be true.
Question 1- A loss on a rental (passive income) cannot write off a
loss against earned income? I am 99% this is a true statement. The
rental PITI without depreciation is a loss, and once depreciation is
added in, it gives the illusion of a gain.
Question 2 (and this is the $100,000 question): If house is
underwater (owe more than house can be sold for) by 50k-100k, and the
FMV for terms of rental will be 50k-100k under same amount, would the
depreciation be end up getting taxed, increasing overall tax
Points regarding question 2:
Person is in high tax bracket (33% or 35%)
If person owed 300k on house and FMV for terms of IRS rental was 200k,
that 100k loss now would not be income (because it is a loss and a
primary residence in 3 of last 5 years).
Once house turned into rental for 3 years, the 3 of last 5 years
primary residence test is lost (no capital gains exclusion) AND
the 200k FMV of house is depreciated (200/27.5=$7200 per year), so
when house is sold for 200k, that $7200 taken in depreciation will be
taxed at 15% (long term capital gains rates).
Rental income might be $2000/mo
House liabilities (PITI) might be $2400/mo
the $4800 loss (per year) is offset by depreciation short term.
So if the house is turned into a rental, there is a 100k loss on house
(based on purchase price) and another loss on sale because of the
By renting, the loss is spread over more years (because person might
pay 300k loan down to 200k over term of rental to give illusion of
What other factors should be considered?
I'm not sure what you mean to say here. Could you correct the grammar
in the post please and clarify? E.g. as regards the above statement:
my understanding is that depreciation is written off against ordinary
income (i.e. it is a loss); the $4,800 loss per year above is the
shortfall of rental income (i.e. rental income doesn't cover PITI);
how can a loss be offset by a loss?
It depends. You should review the details with an accountant. The
thing you're looking for is "passive activity losses". Normally
rental property is considered a passive activity and you *may* be
able to deduct some passive activity losses against your ordinary
income - up to $25,000 each year -- if your MAGI doesn't exceed
$100,000. Between MAGI of $100k and $150k, that phases out. Any
passive activity losses not used get carried forward and accumulate
each year until you finally sell the property (completely).
Here are some details and lots of references:
If you've been carrying losses and then you sell at a loss, you'll
have two competing things in the year of the sale - you'll finally
get to deduct all those carried forward losses, but you'll also have
to pay "depreciation recapture" - since you get to deduct the
depreciation against ordinary income, they want you to pay the
taxes on the "gains" due to the difference between depreciation
and sale price at a higher rate, too. Again, worth going over
the details with an accountant. Depreciation can be very messy.
Even if you just pay the accountant by the hour for an hour
or so of his or her time, probably just a couple of hundred
bucks, it'll probably be worth it. (Probably won't be able
to get any accountant's time before May, though...).
In the meantime, read up on "passive activity losses" (and
passive activity loss limits), and on "depreciation recapture".
Depreciation *increases* the loss. It doesn't offset the loss.
The value of depreciation in increasing a loss is that it may
wipe out taxable current income (or create a possibly deductible
loss). The danger of depreciation, particularly with respect
to something which increases in value (like real estate) is that
you may end up with depreciation recapture later on, but taking
a loss now in exchange for a taxable gain later - especially if
you can put of "later" for a loooooong time - may be substantial.
Nevertheless, you seem to have your depreciation upside down,
at least in the expression "should offset losses".
This question should be posted to misc.taxes.moderated, where I hang out,
but I'll try to answer you here.
First, depreciation is based on the LESSER of Cost or FMV at the date placed
in service. So if you paid $300K for a house that is worth just $200 when
you start renting it your depreciation calculations START with the $200K
number. I say start because you cannot depreciate LAND. So you have to
look to the tax assessment records to get the ratio of land to the total
assessment. Then apply that ratio to the $200K FMV number. This would let
you depreciate maybe $120K for the house with no depreciation for the $75K
worth of land - just an example, YMMV.
Second, rent collected minus expenses INCLUDING depreciation equals
reportable income. Depreciation reduces income, which may result in an
increase in the loss from the activity.
Third, rental losses are only fully deductible, up the $25K max, when AGI is
$100K or less. When AGI breaks the $100K mark you SUSPEND $1.00 of rental
loss for every $2.00 AGI is over $100K. So that at $150K in AGI all rental
losses are suspended and carried forward.
Now, assuming you do all the math correctly at some point you're going to
sell the house. Gain at the time of sale will be calculated the value of
the property when it was placed in service minus any depreciation allowed OR
ALLOWABLE (meaning if you fail to take while renting you still get to pay as
if you did - SO TAKE IT!). The $100K drop in value will NOT come into play
for purposes of calculating any gain or loss from the rental activity.
Fourth, assuming you sell the house soon enough so that you COULD exclude
some of the gain, under the sale of principal home rules, you have to make a
separate calculation using actual cost versus selling price. This may
result in a loss because the $100K is factored back in.
Fifth, it is entirely possible, in your scenario, that you'll have a taxable
gain on the sale of the rental but an actual loss from the sale of the
house. If that happens you get to pay tax at 25% on the recapture of
depreciation taken and capital gains tax on any gain from appreciation EVEN
THOUGH you may have actually sold at a loss (again, because of the $100K).
Sixth, I do not know why you would go through Schedule C with him, unless
this is a true IRC 469 passive rental. ONLY IRC 469 passive rentals go on
Schedule C and that is an entirely different and more complex situation than
the one you seem to be in.
Side issues - please don't take this personally, I'm sure you posted here
because you don't know and are looking for guidance. But is apparent that
you do not have near enough knowledge to run all the calculations necessary
to project any possible tax implications.
You do NOT get to deduct PITI. P is for principle payments, no deduction.
Instead you get deprecation based on the value of the property when placed
in service as a rental, less the allowance for land which you cannot wear
I is for interest - this is deductible.
T is for taxes - this is deductible
I is for insurance - this is deductible.
The amount of any loan is IRRELEVANT when doing tax calculations. Borrowed
money is NOT income, loan repayments are not deductible. I have a case
right now where a client bought 2 lots for $25K about 15 years ago. They
went up in value substantially so at some point he borrowed about $200K
against them. Now the market is depressed and he had to sell them for
$180K. He actually had to BRING money to the table to pay off the loan.
NOW THE REAL GOOD PART - he also has a gain from the sale because he sold
for $180K that which cost him just $25K. So he's looking at Federal and
State taxes, even at capital gain rates, of roughly $30,000 - BUT he got no
cash at settlement (sucks to be him).
I would strongly encourage your friend to meet with a tax professional
BEFORE he starts renting this property. This is an exceptionally convoluted
situation and one in which, in my 30-years of experience as a tax
professional, an ABOVE average person will NOT be able to handle correctly.
Gene E. Utterback, EA, RFC, ABA
Why are you looking at Schedule C?
Are you counting principal payments as part of the rental expenses? That
may be relevant when looking at the cash flow for the property, but you
can only deduct the interest, property tax, and insurance parts on
In the case you've laid out - a high-bracket owner who rents at a loss,
but can't use rental losses because of the passive loss limitation
rules, who sells a few years later at the same price that he placed the
property in service - the loss carry-forwards would more than offset
that recaptured depreciation. The remaining net loss could then be used
against earned income, but that just reduces its sting; it's still a loss.
In effect, the owner would just receive some cash-flow support for
holding the property longer, in the hope of a rebound in price, but
would end up losing more money if it didn't go up in value (because of
the carrying costs - property tax, insurance, upkeep, interest, etc).
There are a couple million vacant homes in the US right now, that were
bought by "investors" using this strategy.