There are two basic (very basic) types of income an individual can receive. Passive income and non-passive income. Non-passive income is more accurately referred to as "earned income".
Non-Passive, or earned income is money that you are paid when you go out and "do" something on a recurring basis to actually "earn" it. This type of income is generally reported to you on a W-2, or on a 1099-MSIC in box 3. It also includes income that you "earn" through self-employment if you are "in business" for yourself.
Passive income is income you receive on a recurring basis that you don't actually "do" anything on a recurring basis to earn it. One example of passive income is rental or royalty income. All you do is "sit there" and collect that income every month. You don't actually go out and "do" anything to earn that income.
Rental income is passive income. Therefore, any expenses incurred or deductions taken for rental property (including depreciation) are considered passive expenses. You can only deduct your passive expenses from passive income. Once those passive expenses gets your taxable passive into to zero, that's it. You can't deduct any remaining passive expenses. Instead, those unallowed passive expenses are carried over to the next year where they can be deducted *if* you have the passive income to deduct them from. But that's not going to happen with rental property. Especially if you have a mortgage on the property.
So with rental property, each passing year your passive carry over expenses will continue to grow. This is perfectly normal and expected.
Now in the tax year you sell the rental property, your passive expenses carried over are no longer restricted to the passive income. Additionally, in the tax year you sell the property you are required to recapture all prior depreciation taken on the property and pay taxes on it. That recaptured depreciation will be taxed anywhere from 0% to a maximum of 25%. Here's how it works in the tax year you sell the property.
- First, all prior depreciation taken on the property is added to your sales price to determine your "adjusted" sales price. This commonly results in a taxable profit on the sale.
- Next, your carried over passive expenses (losses) are deducted from any gain (profit) you realize on the sale, thus reducing the taxable amount of that gain.
- If your taxable gain is reduced to zero and there are still any losses left, then those remaining losses are deducted from other "ordinary" income. (to include your W-2 income). But you can only deduct a maximum of $3000 a year from that other ordinary income.
- If after deducting the maximum allowed from other ordinary income there is still more left over to deduct, the remaining is carried over to the next year where you can deduct up to a maximum of another $3000 from other ordinary income. This will continue each year until all of the losses are used up.
