Depreciation deductions offer tax shelter to real estate investors. Suppose you buy a $400,000 rental home with a $320,000, 8 percent mortgage. Say your net operating income (gross rental income minus operating expenses) is $36,000 while your depreciation deduction is about $24,000.
Thus, from your $36,000 income, you’ll pay (and deduct) $25,600 in interest, leaving you with $10,400 in cash: a 13 percent return on your $80,000 down payment. Your $24,000 depreciation deduction leaves you with a $13,600 loss on paper–you deduct that $24,000 from your $10,400 cash profit. Even though you pocket $10,400, you won’t owe any income tax.
Can you deduct that $13,600 loss? For most people, passive losses up to $25,000 per year are deductible if adjusted gross income (AGI) is under $100,000. If your AGI is over $100,000, your ability to deduct passive losses gradually fades to zero, at an AGI of $150,000.
With a $13,600 loss, as above, you’d need AGI of $122,800 or less, in order to deduct the entire amount. Losses you can’t deduct right away are suspended until you dispose of the property.