7788 / How does real estate shelter income through tax deferral?

When depreciation deductions and any other noncash deductions are large enough, the taxable income from the property can be substantially less than its positive “cash flow” (the amount of cash receipts remaining after subtracting from gross cash receipts all cash expenses and payments on mortgage principal). Often, the noncash deductions produce a loss that partly or totally “shelters” the net cash flow. In many instances, deductions for depreciation and other expenses can produce a tax loss that offsets other taxable income. Because investment in real estate will generally be a passive activity, such losses may normally offset only other passive income of the taxpayer, although passive losses and the deduction-equivalent of credits with respect to certain rental real estate activities may offset up to $25,000 of nonpassive income of an individual. (The passive loss rules are discussed in Q 7793 and Q 8010 through Q 8021.)

However, when mortgage amortization payments exceed the depreciation on the property, taxable income and even the tax itself can exceed the investor’s share of cash flow or tax savings. This taxable but noncash income is often referred to as “phantom income” and, assuming constant rental income and constant mortgage amortization, phantom income can increase each year. The carryover of disallowed passive losses from earlier years may reduce or even eliminate the phantom income in later years. If the individual has not prepared for phantom income, he or she may want to dispose of the investment. The tax consequences of disposition of property, including a partnership interest, are discussed in Q 7753 to Q 7766 and Q 7833 to Q 7836.