Summary: One advantage of investing in rentals for cashflow over other forms of investing, is that you often don’t pay taxes on the profit. This is one of the greatest benefits of investing in real estate. In this article we will show you how you can still generate profit on your rental property, but show a loss on your tax return.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
When comparing real estate investing to other forms of investing, it’s important to consider the tax consequences.
When you sell a stock for a gain, you pay capital gains tax. When you receive a dividend, it’s taxed as ordinary income.
But what about the tax consequences of any profits you make from your rentals?
This is one of the unique aspects of investing in rentals for cashflow.
It’s often the case that you’ll pay zero taxes on the cashflow.
In order to understand how, you’ll first need to understand how taxes are calculated.
How Rental Property Taxes Are Calculated
Taxes are based on net income or loss. This is what you have left over when you subtract all expenses from your rental revenue.
Typical expenses for a rental property are things like insurance, property taxes and utility costs.
What Are Phantom Expenses?
For tax purposes, the IRS lets you deduct other expenses called phantom expenses.
Phantom expenses are exactly what they sound like. They aren’t true expenses. You don’t have to actually pay out of pocket for these expenses.
Typical expenses for a rental property are things like insurance, property taxes and utility costs.
For tax purposes, the IRS lets you deduct other expenses called phantom expenses.
Phantom expenses are exactly what they sound like. They aren’t true expenses. You don’t have to actually pay out of pocket for these expenses.
Rental Property Tax Example: Positive Cashflow with a Tax Loss
Let’s use an example to demonstrate how you can make money from your property, while at the same time, show a loss on your tax return.
Step 1: Calculate Cashflow (Excluding Phantom Expenses)
Let’s say that you have a duplex that you bought for $250,000.
Cashflow is calculated by subtracting operating expenses from rental revenue. You don’t include phantom expenses when calculating cashflow.
The cashflow from this duplex is $5,500. This is the amount that you would have in our pocket at the end of the year.
Step 2: Add Phantom Expenses to Get Your Tax Loss
However, when reporting the income and expenses for this property on Schedule E, you include phantom expenses. When you include phantom expenses, this tips your income into negative territory. In this example, your tax returns show a loss of $5,600.
As you can see with this example, the $5,500 of cashflow isn’t taxed because on paper, this property lost money.
Can You Use Rental Property Losses to Offset W-2 Income?
You might be wondering, can I somehow benefit from these losses?
The answer is, YES!
In certain situations, you can use these losses to offset your W2 or 1099 income. For example, if you make $200,000 per year in salary, the $5,600 loss would lower your taxable income to $194,400.
Two Ways to Unlock These Losses
So what are these situations? One is, qualifying for something called real estate professional status. Another is with the short-term rental tax loophole.
How to Create an Even Bigger Loss Using Bonus Depreciation
Lowering your taxable income from $200,000 to $194,400 isn’t very exciting.
However, with rental properties, there is a way to create an even bigger phantom expense.
This is with something called bonus depreciation.
You can read more about bonus depreciation HERE.
Using the same example as above, we replace the regular depreciation of $9,600 with a much bigger depreciation number of $62,500. This results in a loss of $58,500 instead of just $5,600 with regular depreciation.
This is how you can create large losses to offset W2 or 1099 income when you have real estate professional status or you use the short-term rental tax loophole.
Bonus Depreciation Example: Regular vs. Accelerated
What If You Don’t Qualify for REPS or the Short-Term Rental Loophole?
Many people ask whether or not you have to be a real estate professional or qualify for the short-term rental tax loophole to receive the benefits of investing in real estate. The answer is a resounding NO! While offset income with REPS or short-term rentals is a great benefit, anybody can earn tax-free income from investing in real estate and significantly lower their taxable income.
For example, let’s say you earn half of your income from cashflow and the other half from a job. Assuming the cashflow is tax-free as in the above example, then you just cut your tax rate in half!
Now that’s a great way to jump start your journey to financial freedom.
Want to learn how to build a significant source of income from investing in real estate while reducing your taxes? Join us in one of our courses, Zero to Freedom, or Accelerating Wealth.
Frequently Asked Questions
Rental properties can generate positive cashflow while showing a tax loss because the IRS allows you to deduct “phantom expenses” — primarily depreciation — that don’t require any actual out-of-pocket spending. When depreciation is added to your real expenses on Schedule E, it can push your taxable income below zero even when your bank account shows a profit.
Phantom expenses are tax deductions the IRS allows you to take that don’t require you to spend any money. The most significant phantom expense for rental properties is depreciation — the IRS lets you deduct a portion of the property’s value each year as it theoretically “wears down,” even if the property is actually appreciating in value.
Depreciation is a non-cash tax deduction that lets you deduct a portion of your rental property’s value each year over its useful life (27.5 years for residential properties, according to the IRS). Because it’s a paper expense rather than a real one, it can reduce your taxable income to zero or below without reducing your actual cashflow.
Bonus depreciation allows investors to accelerate depreciation deductions — often in year one — through a cost segregation study. Instead of spreading depreciation over 27.5 years, certain components of the property can be depreciated much faster, creating a significantly larger paper loss. This larger loss can then be used to offset W-2 or other income if you qualify for REPS or the short-term rental tax loophole.
No. Any real estate investor can benefit from tax-free cashflow through depreciation — you don’t need REPS. However, REPS (and the short-term rental tax loophole) unlock the ability to use rental losses to offset W-2 or other non-passive income, which is a much larger tax advantage. Without REPS or the STR loophole, your losses are passive and can only offset passive income.
