Real estate tax strategy
Ted Lanzaro on Investor Status, Depreciation and the Loan Trade-Off
The real estate CPA explains why the same depreciation can wipe out tax for one investor and do little for another, and why piling up deductions can cost you your next loan.
Tax Benefits of Investing in Real Estate
Video from Commercial Real Estate Investing from A-Z.
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How does investor status change the tax value of real estate depreciation?
Depreciation can bring a rental's taxable income down to zero for any owner, but only some investors can use extra losses against wages. Passive investors offset passive income only, active investors earning under $150,000 can deduct up to $25,000, and real estate professionals can deduct it all. Every extra deduction also lowers the income a lender sees.
Most real estate investors hear that depreciation lets them keep rental cash flow without paying tax on it. Fewer realise that what happens to the losses beyond that point depends on how the tax code classifies them, and that the same deductions which shrink a tax bill can also shrink what a bank is willing to lend.
Ted Lanzaro has worked as a real estate investor CPA for about 30 years. He bought his first three single-family rentals in Fort Lauderdale around 2000 after a friend handed him Rich Dad Poor Dad, grew that portfolio to roughly 40 or 50 units, and began giving tax talks at local investment clubs.
On the Commercial Real Estate Investing from A-Z podcast he walked through the three classes of investor, showed how one well-timed purchase changed a client's tax bill, and explained the two costs that aggressive deductions carry: recapture when the property sells, and a weaker case when the investor applies for financing.
Key takeaways
- Residential buildings depreciate over 27.5 years, so the deduction can offset a property's cash flow and leave zero taxable rental income.
- Passive investors can only use rental losses against passive income, while active investors under $150,000 can deduct up to $25,000.
- Real estate professionals need 750 hours in real estate and more than half their working time there, which few W-2 employees can meet.
- Depreciation is a deferral that returns as recapture on sale, and heavy deductions can lower the income lenders use to approve loans.
1. Depreciation does the first job for every investor
Lanzaro starts with the basic arithmetic. A residential apartment building is depreciated over 27 and a half years, so a $2.75 million purchase produces about $100,000 of depreciation expense every year. If that building also throws off $100,000 of net cash flow, the two cancel out and the investor reports zero taxable rental income while the cash stays in the bank.
He pairs that with leverage. Twenty thousand dollars buys twenty thousand dollars of stock, but the same sum can serve as the down payment on a $100,000 property with a mortgage covering the rest. Combine a higher return on the cash invested with income that is not being taxed, and real estate starts to look very different from other investments.
Reaching zero on the property itself does not require any special status. Any owner can get there. The question that separates investors is what happens when depreciation runs larger than the cash flow and creates a loss, because whether that loss can reduce tax on a salary depends on which of three categories the investor falls into.
2. Passive, active or professional decides what a loss is worth
The first category is the passive investor. Lanzaro explains that a passive investor can only deduct rental losses against other passive income. That covers people who put money into someone else's deal without control, and active landlords who earn more than $150,000 a year at a W-2 job. For them, the best realistic result is zero net rental income.
Active investors earning less than $150,000 a year get more room. They can deduct up to $25,000 of rental losses against ordinary earned income such as a salary, so a $25,000 loss on a $100,000 wage leaves tax due on only $75,000. To count as active, he says, an investor manages their own properties and puts in at least 250 hours a year.
Real estate professionals face no cap, but the test is strict: at least 750 hours in a real estate business and more than half of their working time. Lanzaro described a broker who made about $1 million in commissions in 2020, bought an apartment building mid-year, took around $400,000 of bonus depreciation, and cut roughly $160,000 from his tax bill.
3. Every deduction has a cost at sale and at the bank
The first cost is recapture. When that broker eventually sells, the depreciation he claimed comes back as taxable gain, so cost segregation is a deferral rather than an avoidance unless he completes a 1031 exchange. Under the rules in place when he recorded this 2021 interview, he added, bonus depreciation was set to phase down from 100 percent starting in 2023 and disappear by 2027.
The second cost shows up when the investor needs a loan. Lanzaro has seen clients take so many deductions that they could no longer qualify for financing. Banks typically add depreciation back because it is not a cash expense, but converting personal spending into business expenses lowers the net income a lender looks at, and a rental showing $10,000 of meals simply looks wrong.
His advice is to balance the next deal against the biggest possible deduction, keep good records, and tell the accountant during the year what is being bought, sold or renovated. Taking profit out of an LLC as a draw is normal and does not reduce net income, he notes. The goal is a tax result that still leaves the investor able to borrow.
