Tax Strategies for Real Estate Investors

How depreciation, 1031 exchanges, passive loss rules and professional status work, with the conditions and limits that matter.

Depreciation

The IRS lets you deduct the cost of a residential rental building over 27.5 years, and commercial buildings over 39 years. Land is not depreciable, so only the building's share of the price counts.

On a property where the building is worth $500,000, that is roughly $18,000 a year of deductions without spending any cash, which can offset much or all of the rental income on paper.

Depreciation recapture

Depreciation is partly paid back when you sell. The portion of your gain equal to the depreciation you took is generally taxed at up to 25%, rather than at long-term capital-gains rates. Factor this into any sale, and into the case for a 1031 exchange.

Cost segregation and bonus depreciation

A cost segregation study identifies parts of a building, such as appliances, carpeting, fixtures and landscaping, that can be depreciated over 5, 7 or 15 years instead of 27.5. Combined with bonus depreciation, this can move large deductions into the first years of ownership.

The rules for bonus depreciation have changed several times in recent years, and a study has a cost, so it is usually considered for larger properties. Check the current rules with a tax professional.

1031 exchanges

A 1031 exchange lets you defer capital-gains tax and depreciation recapture by reinvesting the proceeds of an investment property into another like-kind property. The deadlines are strict: identify replacement properties within 45 days of the sale, and close within 180 days.

The money must be held by a qualified intermediary, not by you, and any cash you take out is taxable. Exchanges can be repeated, and under current law heirs generally receive a stepped-up basis, which can remove the deferred gain entirely.

Passive loss rules

Rental income and losses are generally passive, so losses can offset only passive income. There is an exception: if you actively participate in managing the rental, you may deduct up to $25,000 of rental losses against other income. That allowance phases out as modified adjusted gross income rises from $100,000 to $150,000.

Real estate professional status

Qualifying as a real estate professional lets you treat rental losses as non-passive, so they can offset wages and other income. The tests are demanding: more than half of your working hours must be in real property businesses, you must spend more than 750 hours a year in them, and you must materially participate in the rentals. The IRS scrutinizes these claims, so keep detailed time records.

Get professional advice

Tax rules are detailed, change often and depend on your whole situation. This guide explains how the main rules work; it is not tax advice. A tax professional who works with real estate investors can pay for themselves many times over.