Real Estate Investor Tax Guide

Rental income is reported on Schedule E and is passive by default

Long-term rental income and expenses go on Schedule E: rents received, operating costs (repairs, management, insurance, mortgage interest, property tax), and depreciation. The net flows to Form 1040.

The catch is character. Under Section 469, a rental activity is passive regardless of how involved you are -- even if you self-manage. Passive losses can only offset passive income, not your W-2 wages or Schedule C profit. So in a year your rental runs a paper loss (common, because depreciation is non-cash), that loss usually does nothing for your tax bill today. It is suspended and carried forward.

Two things break passivity: qualifying as a real estate professional and materially participating, or running a short-term rental that escapes "rental activity" treatment. Both are covered below. Property taxes and mortgage interest on a rental are deducted in full on Schedule E and are NOT subject to the $10,000/$40,000 SALT cap, which only limits personal state and local taxes on Schedule A.

Rental income and expenses are reported on Schedule E. Under Section 469 the activity is passive by default, so rental losses generally cannot offset wages or active business income. Rental property taxes and mortgage interest are fully deductible on Schedule E, outside the personal SALT cap. (IRC Section 469 (passive activity rules); Schedule E (Form 1040); IRC Section 164 (SALT cap applies to Schedule A, not Schedule E))

The $25,000 special allowance -- and how income phases it out

Investors who are not real estate professionals get a limited break. If you "actively participate" -- approve tenants, set rents, approve repairs (a low bar, lower than material participation) -- you may deduct up to $25,000 of rental real estate loss against other income.

But it phases out as income rises:

- Modified AGI at or below $100,000: full $25,000 allowance. - Between $100,000 and $150,000: the allowance drops by $1 for every $2 of MAGI over $100,000. - Modified AGI at or above $150,000: the allowance is fully phased out -- $0.

So a household earning $165,000 with a $9,000 rental loss gets no current deduction; the loss is suspended and carried forward as a passive loss. Those suspended losses are not gone: they release when the activity produces passive income, or in full when you make a fully taxable disposition (sell the property to an unrelated party).

Active participants may deduct up to $25,000 of rental loss against other income, but the allowance phases out between $100,000 and $150,000 of modified AGI and is zero above $150,000. Disallowed losses carry forward and release on full disposition. (IRC Section 469(i) ($25,000 offset and phase-out); IRC Section 469(g) (release on disposition))

Real estate professional status: the way to make rental losses non-passive

Real estate professional status (REPS) under Section 469(c)(7) is the cleanest way to convert rental losses into losses that offset W-2 and business income. To qualify, in a given year you must:

1. Spend MORE than half of your total personal services in real property trades or businesses in which you materially participate, AND 2. Perform at least 750 hours of service in those real property trades or businesses.

A full-time W-2 employee almost never qualifies, because the more-than-half test is measured against all your working hours. REPS is realistic for full-time investors, agents, builders, and property managers (or, in a married couple, the spouse who works the real estate).

REPS alone is not enough -- you must also materially participate in the rental activity (standard Section 469 tests: 500 hours, substantially all participation, or more than any other individual). Because each property is a separate activity by default, most professionals file the election to group all rentals as one activity, making the material participation hours far easier to meet. Get REPS plus material participation, and your rental losses -- including the large ones from cost segregation -- become non-passive.

A real estate professional (more than half of personal services and at least 750 hours in real property trades, with material participation) can treat rental activities as non-passive, so the losses offset wages and active income. A grouping election helps meet material participation. (IRC Section 469(c)(7) (real estate professional); Treas. Reg. Section 1.469-9 (grouping election); Section 469 material participation tests)

Depreciation: a large deduction you cannot decline

Depreciation is the engine of real estate tax benefits. You deduct the cost of the building (not the land) over its recovery period using straight-line MACRS:

- Residential rental property: 27.5 years. - Non-residential (commercial) property: 39 years.

On a $400,000 property with $50,000 allocated to land, the $350,000 building yields roughly $12,700 of annual depreciation -- a deduction that often turns a cash-flow-positive rental into a paper loss.

Important: depreciation is not optional. The tax code reduces your basis by depreciation "allowed or allowable," meaning the IRS treats you as having taken it on sale even if you forgot to claim it. So skipping depreciation gives you the worst of both worlds: no deduction now, and full recapture later. Always claim it.

Buildings depreciate straight-line over 27.5 years (residential) or 39 years (commercial); land is not depreciable. Depreciation is mandatory in effect -- basis is reduced by depreciation allowed or allowable, so unclaimed depreciation is still recaptured on sale. (IRC Section 168 (MACRS recovery periods); IRC Section 1016 (basis reduced by depreciation allowed or allowable))

Cost segregation and 100% bonus depreciation

A cost segregation study breaks a building into components and reclassifies the shorter-lived ones -- appliances, carpeting, cabinetry, land improvements, certain wiring -- into 5-, 7-, and 15-year property instead of burying them in the 27.5- or 39-year shell.

That matters because shorter-life property qualifies for bonus depreciation, which under OBBBA is 100% and permanently restored for qualifying property placed in service after January 19, 2025. A cost-seg study can therefore pull tens of thousands of dollars of depreciation into year one. The building shell itself (27.5/39-year) never gets bonus depreciation; only the reclassified components do.

The strategy only pays off if you can USE the loss. For a non-professional with passive rentals, a giant cost-seg loss is still passive -- it gets suspended and banked, not deducted against wages. Cost segregation delivers its headline benefit when paired with real estate professional status or a materially participated short-term rental, where the loss is non-passive.

Cost segregation reclassifies building components into 5/7/15-year property eligible for 100% bonus depreciation (restored permanently under OBBBA for property placed in service after January 19, 2025). The building shell does not qualify, and the resulting loss is only usable against wages if the activity is non-passive. (IRC Section 168(k) (bonus depreciation, 100% under OBBBA); cost segregation under IRC Section 168 component classification)

Depreciation recapture: the bill comes due on sale

Every dollar of depreciation you deduct reduces your basis, which increases your gain when you sell. On the sale of real property, the portion of gain attributable to depreciation is "unrecaptured Section 1250 gain," taxed at a maximum federal rate of 25% -- higher than the 0/15/20% long-term capital gains rate that applies to the remaining appreciation.

Example: you bought for $400,000, claimed $90,000 of depreciation (basis now $310,000), and sell for $520,000. Your $210,000 gain splits into roughly $90,000 of unrecaptured Section 1250 gain taxed up to 25%, and $120,000 of long-term capital gain taxed at 0/15/20%. Personal property components expensed via cost segregation can face steeper Section 1245 recapture at ordinary rates. This is why investors plan their exits -- via a 1031 exchange, an installment sale, or holding -- rather than simply selling.

On sale, gain attributable to depreciation is unrecaptured Section 1250 gain taxed at up to 25%; the remaining appreciation gets long-term capital gains rates. Cost-segregated personal property can face Section 1245 recapture at ordinary rates. (IRC Section 1250 (real property recapture, 25% maximum); IRC Section 1245 (personal property recapture))

Section 1031: defer the gain by exchanging into more real estate

Section 1031 lets you defer both capital gain and depreciation recapture by exchanging investment real property for other like-kind real property. Since the 2018 TCJA changes, 1031 applies only to real property -- not equipment, not crypto -- but real-estate-for-real-estate is broadly defined (an apartment building for raw land, a rental house for a commercial unit).

The rules are strict and the clock is unforgiving:

- You cannot touch the proceeds; a qualified intermediary must hold them. - 45-day identification window: you must identify replacement property in writing within 45 days of selling. - 180-day exchange period: you must close on the replacement within 180 days (or your return due date including extensions, if earlier). - To defer all gain, the replacement must be of equal or greater value and you must reinvest all equity; cash or debt relief you keep ("boot") is taxable.

Done repeatedly, 1031 can defer gain across an entire investing career; the deferred gain is wiped out entirely if the property passes to heirs at a stepped-up basis.

Section 1031 defers gain and recapture when investment real property is exchanged for like-kind real property through a qualified intermediary, within a 45-day identification window and 180-day closing period. Boot (cash or net debt relief) is taxable. (IRC Section 1031 (like-kind exchanges, real property only since 2018); Treas. Reg. Section 1.1031(k)-1 (deferred exchange timing); Form 8824)

Short-term rentals, NIIT, and the QBI deduction

Short-term rentals are taxed differently and deserve their own analysis (see the dedicated short-term-rental guide). In brief: if the average guest stay is 7 days or less, the activity is not a "rental activity" under Section 469. With material participation, its losses are non-passive and can offset wages -- the "short-term rental loophole" that makes cost segregation so powerful for active hosts.

Two more layers apply to all rental investors. The 3.8% Net Investment Income Tax hits net rental income once modified AGI exceeds $200,000 (single) or $250,000 (married filing jointly), though income that is non-passive to a real estate professional can be excluded. And the Section 199A qualified business income deduction (20%) can apply to rental income that rises to a trade or business -- the IRS safe harbor treats a rental enterprise as a business if you log at least 250 hours of rental services per year and keep contemporaneous records (Rev. Proc. 2019-38).

Short-term rentals with a 7-day-or-less average stay are not Section 469 rental activities, so material participation makes losses non-passive. Net rental income can face the 3.8% NIIT, and rentals rising to a trade or business may qualify for the 20% QBI deduction under the 250-hour safe harbor. (Treas. Reg. Section 1.469-1T(e)(3) (7-day exception); IRC Section 1411 (NIIT); IRC Section 199A and Rev. Proc. 2019-38 (rental safe harbor))