At one time depreciation was used by the wealthy to reduce their sizeable incomes. They would take the loss from their property primarily attributable to depreciation (it occurred only on paper) and deduct it from their ordinary income. That reduced their ordinary income, which, of course, reduced the amount of taxes they would owe on that income. That tax shelter was eliminated for the wealthy by the Tax Reform Act of 1986. Now deducting a loss is only available if your income is less than $150,000. The maximum deduction is $25,000 and you lose 50 cents for every dollar of that for income you make over $100,000, up to $150,000. However, in order to qualify you need to take an active part in the management of the property. See a good accountant on this one.

Why must I participate in management?

The Tax Reform Act of 1986 changed the rules with regard to real estate taxation. We now have three categories of income:

1.Active Income. The tax law now discriminates among the types of income that we receive. Income from wages or as compensation for services is called active income. It includes commissions, consulting fees, salary, or anything similar. It’s important for those involved in real estate to note that profits and losses from businesses in which you “materially participate” (not included are limited partnerships) are included. However, activities from real estate are specifically excluded.

2.Passive Income. In general, passive income means the profit or loss that we receive from a business activity in which we do not materially participate. This includes not only limited partnerships, but also income from any real estate that is rented out. Ifs important to note that real estate is specifically defined as “passive”.

3.Portfolio Income. Income from dividends, interest, royalties, and anything similar is considered portfolio income. We need not worry much about this here except to note that it does not include real estate income.

Under the old law, income was income and loss was loss. You could thus deduct most losses on real estate from your other income. Under the current law, your personal income is considered “active” while your real estate loss is considered “passive”. Since you can’t deduct a passive loss from an active income, you can’t, in general, write off any real estate losses. The exception is for the investor (income under $150,000 as described above), who materially participates in the property’s management. If you own the property and are the only person directly involved in handling the rental you advertise it, rent it, handle maintenance and clean-up, collect the rent, and so on then, generally speaking, you materially participate.

What if I hire a property management firm?

This is a gray area. Generally, if you don’t personally determine the rental terms, approve new tenants, sign for repairs, approve capital improvements, and the like, then you may not qualify. Many property management firms will offer to do these things for you. However, if you do them yourself, you’re probably still okay. Remember, you will probably need to determine rental terms, approve new tenants, sign for repairs, approve capital improvements, and the like. If you are going to use a management firm, be sure that you have your attorney check over the agreement you sign with the firm to see that it does not characterize you as not materially participating and thus prevent you from deducting any loss.