Tax savings from rental property losses

Dear Tax Talk,
My wife is an attorney and I'm a real estate agent. We are trying to figure out the best way to decrease our taxes. Our household income ranges from $150,000 to $220,000 and we file jointly. We are maximizing our 401(k) and other savings vehicles. We have done our homework and have found a great investment property that could pay for itself. Is purchasing rental property a good way to decrease our tax base? -- Christopher

Dear Christopher,
For most folks at your level of income, a loss from rental property would not be a big benefit income tax-wise. Losses from rental activities for most individuals are not allowed to offset other income such as wages if their adjusted gross income exceeds $150,000. A significant exception exists for a real estate professional such as you.

While entering into any business with the intention of incurring losses usually is not a formula for success, the real estate business is different. Most leveraged real properties will incur a taxable loss during their operation. Generally, this comes about by the allowance for depreciation of the property and sometimes from negative cash flow.

In figuring your profit from the property, you're allowed a deduction of your cost at roughly 4 percent per year. On a $200,000 property this means you have an approximate $8,000 tax deduction that does not come out of your pocket.

The other side of the coin is that although you're losing for tax purposes, your property is usually appreciating in value annually. This appreciation is not taxed until you sell the property and you can defer the tax even then by doing a like-kind exchange. In addition, as the property appreciates, you can borrow against it tax-free and buy more property.

While most people can't use the tax deduction due to passive activity limitations when their income exceeds $150,000 (see Internal Revenue Service Publication 925), a significant exception exists for a real estate professional. A real estate professional is generally a developer, property manager or broker. If you're in this category, your losses would not be limited under the passive activity rules.