“Well, real estate is always good, as far as I’m concerned.”
– Donald Trump
Ah, the joys of home ownership. You get the white picket fence, the dog, the 2.5 kids, and you live in idyllic bliss.
Until you find out that your job has been downsized or that corporate headquarters wants you to take a new role in the office three states away.
You bought your house right at the peak of the real estate bubble, and it’s currently worth 20% less than it was when you bought it.
This isn’t a very uncommon scenario. According to the Harvard Business Review, 20% of people who were laid off and found new jobs had to relocate to a different city or state, and 23% of homes are underwater.
If you find yourself in this situation, what’s your gut reaction?
It was the one that we had when we moved from Virginia to Texas. Our condo in Virginia was down about 23% from what we’d put into it. But, we didn’t want:
- To have to manage a property in another state.
- To have that money tied up in the condo.
- To have to mess with it.
So, we listed the property for what we thought was a fair price. Months ticked by, and we never got an offer. Fortunately, having no mortgage put us in a position where we didn’t have to accept a fire sale offer, but, as we’ll see later, even with a mortgage, it might not be wise to sell.
We finally decided to give up the efforts to sell right now and rent the property out instead. While the cap rate on that property is lower than the cap rate that we can get here, we might have lucked into the right strategy after all.
Why the Internal Revenue Service Treats Gains and Losses on Your House Differently
A lot of people know about capital gains taxes. If you invest in the stock market, then you probably see them every year when you’re filing taxes.
Capital gains means the profit that you make on an investment which you make. There are short-term (12 months or less) and long-term (greater than 12 months) capital gains. Short-term capital gains are generally taxed at your normal income tax rate, and long-term capital gains are generally taxed at 20%. There are some exceptions to this rule, and you can, if you’re longing for some nighttime reading material, go check out the Internal Revenue Service’s website about the tax rates.
The Internal Revenue Service includes your house in capital assets, although it does have some special treatment for the gains and losses that you incur when you sell your home. The happy scenario is when you sell your house for more than you put into it (called your basis). You have a capital gain. Yippee! The IRS would usually want a piece of that action and to take 20% (assuming you owned your home for more than two years), but you can exclude up to $250,000 of gain if you’re single, and $500,000 if you’re filing jointly from those capital gains. If John and Sally buy a house for $200,000 and sell it more than two years later for $700,000, then there is no tax on the gain made from the sale of the home. If they sell it for $800,000, then there would be a $20,000 tax on the gain, since they could exclude $500,000 of the $600,000 gain and would have to pay 20% on the $100,000 gain that they could not exclude.
So far, so good.
What happens if you sell the house at a loss, though?
Nada. Zilch. You don’t get to take a capital gains loss and apply it against your other capital gains. No soup for you. Sad trombone. You get to suck it up and deal with the loss.
Furthermore, mentally, you’re going to be chasing your losses. Monkey Brain will take over and tell you that you lost money on the previous house, so you’d better make a lot of money on the next house! Welcome to prospect theory in real estate. It’s not just for stocks!
That money disappears into the ether as far as you’re concerned, never to be seen again.
What if I told you that there was a way to capture some of that difference as long as you were willing to be patient and think outside the box?
If you’re concerned about doing your taxes correctly, I’ve used
TurboTax Online for several years, and, despite the complicated status of our taxes, have had no problems filing my taxes, saving us almost $1,000 compared to what we were paying our accountant when he prepared our taxes.
How to Use Depreciation to Capture Lost Market Value
Before we get going, I need to explain a concept here. It’s called depreciation. It’s the notion that, over time, an item uses its usefulness. Cars eventually stop working. Houses eventually fall down. Software gets outdated the moment you install it. You get the idea.
When businesses purchase items that are used in the generation of revenue, the IRS allows the business to deduct a portion of the reduced usefulness of the item against revenues each year. Let’s say that you’re a farmer and you buy a truck for your farm to haul hay to the market. You buy it for $20,000. The Internal Revenue Service says that trucks have a five-year lifespan, so over the next five years, you get to take $4,000 for depreciation and use it to reduce the taxable income on your farm. Depreciation lowers your basis in that asset. So, if after a year, you decide to upgrade on trucks, and you sell the truck, you use $16,000 as your basis, since you’ve taken $4,000 in depreciation.
If you’re a homeowner, you don’t get to take depreciation because you’re living in the house. You’re not using that house to generate income (unless you have a home office or are renting out the basement or something, but let’s skip that exception for the purposes of this discussion), so there’s no reason for you to take depreciation. Depreciation is only used when you have income to offset.
There is a way that you can lower the basis in your home and use that depreciation to recapture some of the lost market value.
Rent your house out.
You’re moving anyway. There are three scenarios you face, two of which are pretty nasty:
- Sell the house at a loss. Wave bye-bye to that lost market value.
- Carry the costs of two houses while you wait for the market to recover. Chances are that this means you’ll be paying two mortgages. I’ve had to make two housing payments before. It sucks. Don’t do that.
- Rent out the house. Get income, use mortgage depreciation, and recapture some of that lost value. Yay!
Let me explain the general framework of how to make this work.
We’re utilizing depreciation to reduce the amount of income from renting the property out that is taxable. If you don’t have a mortgage, then depreciation will usually be your biggest expense to offset against rental income in a given year. If you do have a mortgage, then it will probably be up there with interest as one of the two biggest expenses to offset the rental income. The net effect is that these expenses reduce the amount of rental income on which you have to pay taxes.
What if you don’t make enough in rent and have a loss on the house at the end of the year? You are still able to offset up to $25,000 in losses against your other income if your modified adjusted gross income (MAGI) is under $100,000 if you’re married filing jointly. After $100,000, it’s reduced by 50%, meaning that you can’t reduce your income with the rental real estate loss after a MAGI of $150,000. However, to qualify, you must actively participate, meaning, from IRS Publication 527:
You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.
The benefit of this offset is that you’re able to, year by year, reduce your taxable income by the amount of depreciation and loss – an after-tax recapture of lost value – while waiting either for the market to recover or for your basis to drop down to the market value.
Let me walk through an example to show you what happens. It’s not the cure-all magical solution, but it can help ease the pain.
Joe and Suzy Homeowner have a house that they paid $200,000 for. $50,000 is land, and $150,000 is the house. Their effective tax rate is 28%. Their MAGI is low enough to allow for maximum passive loss offsets. The house currently could sell for $150,000 – $30k for the land and $120k for the house – and they could rent it for $10,000 a year, while their expenses (mortgage interest, insurance, property taxes, repairs, etc.) would also be $10,000 a year. The housing market improves 5% every year.
- Scenario 1: Sell the house. They could sell the house and get $150,000 for it, taking a $50,000 loss.
- Scenario 2: Rent the house out until the market recovers to the initial purchase price. At the rate of growth, this would take 6 years. Each year, they would be able to reduce the amount of taxable income by $4,363.63 (the depreciation basis is the lesser of the purchase price or the market value when you convert, see IRS publication 527 for details); the calculation is $120,000 house basis / 27.5 years), meaning that they would increase their after-tax income by $1,221.81. At the end of the sixth year, when they sell, they will have a capital gain of $1,014.40. Because the gain is due to depreciation, they will have to pay depreciation recapture tax for the excess gain – 25% on the $26,181.84 in depreciation that they took, and pay 20% on the remainder of the $1,014.40 capital gain. Note: You can read more about depreciation recapture in my article on PT Money, “Depreciation Recapture and Your Rental Property: The IRS Giveth and Taketh Away.”
Even if you can take the capital gains tax exclusion (say, you sold it in two years), you still have to pay depreciation recapture tax.
Thus, the tax bill will be $6,748.33. But, they’ll make $1,014.40 over what they originally paid for the house and they will have had $7,330.92 more in after-tax income, meaning that they will be $1,394.07 to the good – better than losing $50,000 in scenario 1! It’s a difference of $51,394.07.
You can see by the assumptions which I used that there are a lot of variables which come into play in making this decision. Projected market recovery and rents versus expenses are two of the main factors which you have to consider. You should never let the tax implications of a decision be the primary factor in determining whether or not any investment decision is good one. However, depreciation and passive losses can turn a marginal decision into a clearer one and may make you decide to hold onto your property for a little while.
Depreciation won’t help you recover all of your losses, but it can help you recover a percentage of them.
Here are some good resources to look at regarding the taxation issues I discussed in this article:
- IRS Rental Loss Passive Income Loss Guide
- IRS Topic 425 – Passive Activities – Losses and Credits
- IRS Reporting Rental Income, Expenses, and Losses
- IRS Form 8582 – Passive Activity Loss Limitations
What do you think? Does this raise questions in your mind? Let’s talk about it in the comments below!
- John Davis is a nationally recognized expert on credit reporting, credit scoring, and identity theft. He has written four books about his expertise in the field and has been featured extensively in numerous media outlets such as The Wall Street Journal, The Washington Post, CNN, CBS News, CNBC, Fox Business, and many more. With over 20 years of experience helping consumers understand their credit and identity protection rights, John is passionate about empowering people to take control of their finances. He works with financial institutions to develop consumer-friendly policies that promote financial literacy and responsible borrowing habits.
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