Real Estate Investment Tax FAQ

Depreciation is a powerful tax benefit that allows real estate investors to deduct the cost of residential rental property over 27.5 years and commercial property over 39 years, even while the property may be appreciating in value. Under IRC Section 168, you can only depreciate the building structure, not the land, so you must allocate your purchase price between land and improvements. For example, if you purchase a rental property for $500,000 and allocate $100,000 to land and $400,000 to the building, your annual depreciation deduction would be approximately $14,545 ($400,000 divided by 27.5 years).

This non-cash deduction reduces your taxable rental income, potentially creating paper losses even when you have positive cash flow. Cost segregation studies can accelerate depreciation by identifying personal property components (carpeting, appliances, certain fixtures) that can be depreciated over 5, 7, or 15 years instead of 27.5 or 39 years. Bonus depreciation under IRC Section 168(k) may allow immediate deduction of certain qualifying property. However, when you sell the property, depreciation recapture under IRC Section 1250 requires you to pay tax on the depreciation you claimed at a rate of up to 25%.

A 1031 exchange, named after IRC Section 1031, allows real estate investors to defer capital gains taxes by exchanging one investment property for another "like-kind" property. Like-kind is broadly interpreted for real estate, meaning you can exchange an apartment building for raw land, a retail center for an office building, or any combination of investment real properties. The exchange must follow strict rules: you must identify replacement properties within 45 days of selling your relinquished property and close on the replacement property within 180 days.

You must use a qualified intermediary (QI) to hold the proceeds - if you receive the cash directly, the exchange fails. The replacement property must be of equal or greater value, and you must reinvest all the net proceeds to fully defer taxes. If you receive cash or reduce your mortgage debt ("boot"), that portion becomes taxable. Common 1031 exchange structures include simultaneous exchanges, delayed exchanges, reverse exchanges (buying replacement first), and improvement exchanges. The tax deferral can be repeated indefinitely, and if you hold property until death, your heirs receive a stepped-up basis, potentially eliminating the deferred gain entirely.

Capital gains on investment real estate sales are taxed based on your holding period and income level. Properties held more than one year qualify for long-term capital gains rates of 0%, 15%, or 20% depending on your taxable income, plus a potential 3.8% Net Investment Income Tax (NIIT) for high earners under IRC Section 1411. Short-term gains on properties held one year or less are taxed as ordinary income at rates up to 37%. Your capital gain is calculated as the sale price minus your adjusted basis (original purchase price plus improvements minus depreciation claimed).

Depreciation recapture under IRC Section 1250 is taxed at a maximum rate of 25%, regardless of your income bracket. For example, if you purchased a property for $300,000, claimed $50,000 in depreciation, made $30,000 in improvements, and sold for $500,000, your adjusted basis would be $280,000 ($300,000 - $50,000 + $30,000), creating a total gain of $220,000. Of that, $50,000 would be depreciation recapture taxed at up to 25%, and $170,000 would be capital gain taxed at long-term rates. State capital gains taxes may also apply. Use our capital gains tax calculator to estimate your specific tax liability before selling.

Rental income is generally taxed as ordinary income but offers numerous deductions that can significantly reduce your tax burden. You must report all rental income received, including rent payments, advance rent, security deposits (if not returned), and payments for canceling a lease. Deductible expenses include mortgage interest, property taxes, insurance, repairs and maintenance, property management fees, utilities paid by the landlord, advertising costs, legal and professional fees, travel expenses to manage the property, and depreciation.

The distinction between repairs (currently deductible) and improvements (capitalized and depreciated) is crucial - repainting is a repair, but adding a room is an improvement. Passive activity loss rules under IRC Section 469 may limit your ability to deduct rental losses against other income. However, if your adjusted gross income is under $100,000, you may deduct up to $25,000 in rental losses if you actively participate in management. Real estate professionals who spend more than 750 hours annually in real estate activities and more than half their working time in real estate may qualify for an exception allowing unlimited loss deductions. The 20% qualified business income (QBI) deduction under IRC Section 199A may also apply to rental income if certain requirements are met.

Converting a primary residence to rental property creates complex tax implications when you eventually sell. Under IRC Section 121, you can exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains on the sale of your primary residence if you owned and used it as your main home for at least two of the five years before the sale. When you convert to rental, the clock keeps running on both the ownership and use tests.

However, the Housing Assistance Tax Act of 2008 introduced "nonqualified use" rules that prorate the exclusion. Periods after 2008 when the property was not your principal residence (except for certain exceptions) reduce your excludable gain proportionally. For example, if you lived in a home for 3 years, then rented it for 2 years before selling, only 60% of your gain (3 out of 5 years) would qualify for the exclusion. Additionally, you cannot exclude any depreciation claimed during the rental period - this depreciation recapture is taxed at up to 25% regardless of the Section 121 exclusion. Strategic planning about when to sell can maximize your exclusion while minimizing depreciation recapture and capital gains taxes.

Qualified Opportunity Zones (QOZs), established by the Tax Cuts and Jobs Act of 2017, offer significant tax incentives for investing capital gains in designated economically distressed areas. When you invest capital gains into a Qualified Opportunity Fund (QOF) within 180 days of realizing the gain, you receive three potential benefits: temporary deferral of the original gain until December 31, 2026 (or earlier sale of the QOF investment), basis step-up that previously reduced the deferred gain by 10% after 5 years and 15% after 7 years (these deadlines have passed for most investors), and permanent exclusion of any appreciation on the QOF investment if held for at least 10 years.

The 10-year exclusion is the most valuable current benefit - if your QOF investment appreciates significantly, that entire appreciation is tax-free. QOFs must hold at least 90% of assets in qualified opportunity zone property, which includes qualified opportunity zone stock, partnership interests, or business property. The property must be substantially improved if purchasing existing buildings (improvements must exceed the adjusted basis within 30 months). These investments carry significant risk and illiquidity but can provide substantial tax benefits for the right investors with eligible capital gains.

An installment sale under IRC Section 453 allows you to spread capital gains recognition over multiple tax years by receiving payment over time rather than in a lump sum. When you sell property and receive at least one payment after the tax year of sale, you can report gain proportionally as you receive payments. The installment method calculates a "gross profit ratio" by dividing your total gain by the total contract price, and each payment is taxed at that ratio.

For example, if you sell a property for $1 million with a $400,000 gain (40% gross profit ratio), and receive $200,000 per year over five years, you would recognize $80,000 of gain each year (40% of $200,000). Benefits include spreading income across lower tax brackets, deferring tax payments, and potentially avoiding the 3.8% NIIT by keeping income below thresholds. However, depreciation recapture must be recognized in the year of sale regardless of when payments are received. Interest charged on the deferred payments is taxable income to you and must be at least the applicable federal rate (AFR) to avoid imputed interest rules. Installment sales can be combined with other strategies but cannot be used for sales to related parties in certain circumstances or for dealer property (inventory).

The tax treatment differs dramatically between inherited real estate and gifted real estate, primarily due to basis rules. When you inherit property, you receive a "stepped-up basis" under IRC Section 1014 equal to the fair market value at the decedent's date of death (or alternate valuation date if elected). This means all appreciation during the decedent's lifetime is never taxed. If your parent bought a property for $100,000 that's worth $500,000 at death, your basis becomes $500,000 - you could sell immediately with zero capital gains.

In contrast, when you receive property as a gift, you receive "carryover basis" under IRC Section 1015 - the donor's original basis transfers to you. Using the same example, if your parent gifts you the property worth $500,000 with their $100,000 basis, you inherit that $100,000 basis and would owe capital gains on $400,000 if you sold. For property with built-in losses, different rules apply to prevent loss harvesting through gifts. The donor may also owe gift tax if the gift exceeds annual exclusion amounts ($18,000 per recipient in 2024) and lifetime exemption. Estate planning often favors holding appreciated property until death rather than gifting, though other factors like asset protection and income shifting may influence decisions.