Strategy: John can enter into a tax-deferred exchange for another investment property. Not only will he owe tax on the buildingРІР‚в„ўs appreciation, he also will owe tax on all the depreciation deductions he has taken. Tax trap: If John sells the building, he faces a sizable tax bill. He no longer wants to manage the apartment building near his current home in Connecticut. Assume that John Smith is about to retire and move to Florida. TAX-DEFERRED EXCHANGESР”Р‡ast-forward several years. Going forward: That $8,500 can be carried forward indefinitely to future years when it can be deducted against passive activity income.Р”Р„ny passive losses that still exist may be deducted when the property is sold. If he deducts $7,500, what happens to the other $8,500? Result: John not only has $24,000 in untaxed cash flow, as described above - he also has a $7,500 loss that he can deduct from his ordinary income this year.Р”Р„bove, it was shown that JohnРІР‚в„ўs reported loss from the deal was $16,000 this year. Thus, he can take only 30% ($7,500) of the $25,000 maximum deduction. By $150,000 in AGI, no such deduction is permitted.Р”В®xample: John SmithРІР‚в„ўs AGI this year is $135,000. If your AGI is more than $100,000, that $25,000 maximum deductible loss phases out. Required: To take a $25,000 loss, your adjusted gross income (AGI) must be under $100,000.

For most taxpayers, passive losses up to $25,000 per year can be deducted.

Key: The tax treatment is subject to the РІР‚Сљpassive activity lossРІР‚Сњ rules that generally apply to investment property. Can they go one step further, and deduct a net loss from ordinary income that year? DEDUCTING LOSSESР”Р„lthough the above example is simplified, it is true that real estate investors in a successful venture can collect untaxed cash flow. When he sells the property, this basis reduction will either increase the tax he owes or decrease his reported capital loss. His cost basis in the property is reduced by his $40,000 depreciation deduction. He pockets $24,000.Р”В¬aution: This $24,000 is not totally tax free. With a net loss from the deal, John owes no income tax on his rental income. His operating income is $80,000, but he deducts a total of $96,000 for interest and depreciation. Result: John now has a $16,000 net loss from this investment, for tax purposes. The actual amount will depend on the allocation between land and building as well as the allocation within the building to furnishings, fixtures, etc.Р”Р„ssume, for this example, that John is entitled to $40,000 worth of depreciation on his $1 million apartment building. Tax break: John also is entitled to take depreciation deductions. That is the $80,000 from operations minus the $56,000 he pays in loan interest. Therefore, his cash flow from the building is $24,000. ThatРІР‚в„ўs the excess of rental income from tenants over JohnРІР‚в„ўs expenses for utilities, insurance, repairs, etc. The loan calls for interest-only payments.Р”В¬ounting the cash flow: Assume that the buildingРІР‚в„ўs operating income this year is $80,000. He makes a $200,000 down payment and borrows the remaining $800,000 at 7%. John Smith buys a small apartment building near his home for $1 million. The following simplified example can illustrate some of these tax breaksРІР‚В¦ TAX-FREE CASH FLOW WhatРІР‚в„ўs more, tax advantages may make a good real estate investment even better. The pullback in real estate prices in many areas of the US might offer buying opportunities for careful investors.

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