What Are the Essential Tax Considerations for Real Estate Investors?
Real estate investing delivers cash flow, appreciation, and tax attributes that can materially improve after-tax returns — but only with correct application of the rules. Below I explain the core federal tax topics every investor should understand, pragmatic planning points I use with clients, and where to go for authoritative guidance.
Quick overview
- Rental income is taxable, but many ownership costs are deductible against that income.
- Depreciation reduces taxable rental income during ownership but can trigger depreciation recapture when you sell.
- Capital gains taxes (and the 3.8% Net Investment Income Tax when applicable) apply on sale; a like-kind (Section 1031) exchange can defer tax on qualifying real property.
- Passive activity loss rules and the real estate professional exception determine whether rental losses offset other income.
(Author’s note: In my 15 years advising investors, careful year-by-year bookkeeping and advance planning around sales/events has saved clients tens of thousands in taxes and prevented costly audit adjustments.)
Income and deductible expenses
Taxable rental income includes rent received and certain payments from tenants. Allowable ordinary and necessary expenses that reduce that income commonly include:
- Mortgage interest, property taxes, and casualty insurance.
- Operating costs: property management fees, utilities you pay, repairs, and advertising.
- Professional fees: accounting, legal, and tax preparation related to the rental.
- Home office deductions may apply for landlords who run their rental business from home (subject to strict IRS rules).
Keep original receipts, canceled checks, bank statements, and a consistent chart of accounts. Good records substantiate deductions in the event of an IRS inquiry (IRS: Real Estate Tax Tips: https://www.irs.gov/businesses/small-businesses-self-employed/real-estate-tax-tips).
Depreciation: how it reduces taxable income now (and creates future tax)
Depreciation lets owners recover the cost of rental property (building—not land) over time. For residential rental property the federal recovery period is 27.5 years; for nonresidential real property it is 39 years (MACRS).
Depreciation lowers taxable rental income each year but reduces your adjusted basis. On sale, previously claimed depreciation can be “recaptured” and taxed differently (see Depreciation Recapture below).
For practical guidance on forms and calculations see Form 4562 (Depreciation and Amortization) and our in-depth primer on Depreciation.
Note on bonus depreciation and Section 179: rules changed under the Tax Cuts and Jobs Act and include phase-downs for bonus depreciation for property placed in service after 2022. Check Form 4562 instructions and current IRS guidance before claiming accelerated deductions: https://finhelp.io/glossary/form-4562-depreciation-and-amortization/.
Passive activity loss rules and the real estate professional exception
Since the Tax Reform Act of 1986, rental activities are generally treated as passive. Passive losses normally cannot offset nonpassive income (wages, business income). Two key exceptions:
- The $25,000 special allowance for active participation in rental real estate (phases out for high-income taxpayers). Active participation requires a significant but not full-time role.
- The real estate professional exception: if you materially participate and you spend more than 750 hours per year in real property trades or businesses and more hours in those activities than in other trades or businesses, rental activities may be nonpassive and losses can offset other income. The test is strict and should be documented.
Document hours and activities contemporaneously. Investors who qualify as real estate professionals often realize substantial tax benefit by treating rental losses as nonpassive.
(IRS guidance on material participation and passive activities is available through its publications and should be consulted for specific situations.)
Capital gains, Net Investment Income Tax (NIIT), and 1031 exchanges
When you sell investment real estate, you generally recognize capital gain or loss measured as the sale price minus your adjusted basis (original cost plus capital improvements minus accumulated depreciation). Long-term capital gains (owned > 1 year) are taxed at preferential rates: 0%, 15%, or 20% depending on taxable income (plus any applicable state tax).
High-income investors may also owe the 3.8% Net Investment Income Tax (NIIT) on net investment income when modified adjusted gross income exceeds statutory thresholds ($200,000 single / $250,000 married filing jointly).
1031 like-kind exchanges (IRC §1031) permit deferral of capital gains and depreciation recapture tax when proceeds are reinvested in a qualifying replacement property under strict timelines and rules. Note: only real property qualifies for 1031 exchanges after the 2017 tax changes — personal property exchanges are not eligible.
For sales involving depreciation deductions, remember depreciation recapture rules below. For detailed reporting on rental property sales see our article on Tax Reporting for Rental Property Sales: Gain, Loss, and Depreciation Recapture.
Depreciation recapture
When you sell depreciated property, some or all of the gain attributable to prior depreciation deductions may be taxed as ordinary income or as “unrecaptured Section 1250 gain” with a maximum federal rate of 25% for most real property. Personal property (e.g., furniture, fixtures) may be subject to Section 1245 recapture and taxed at ordinary income rates.
Misunderstanding or failing to plan for recapture is a common and costly mistake. Our detailed coverage of Depreciation Recapture explains typical calculations and reporting steps.
Entity selection, pass-through considerations, and retirement accounts
Choice of ownership (individual, partnership/LLC, S corporation, C corporation, or trust) affects tax filing, liability, and estate planning. LLCs taxed as partnerships or disregarded entities are common because they preserve pass-through taxation while offering liability protection. However:
- S corporations can reduce self-employment tax on certain income but add complexity.
- C corporations create double taxation on distributions in many cases.
Real estate inside retirement accounts (self-directed IRAs or solo 401(k)s) has special rules: unrelated business taxable income (UBTI) and unrelated business taxable income from debt-financed property (UBTI/UBD) can create current tax inside the tax-sheltered account. Consult a professional before moving property or debt into a retirement vehicle.
Recordkeeping, reporting, and common pitfalls
Best practices:
- Keep separate bank accounts and detailed ledgers for each property.
- Track capital improvements separately from repairs. Improvements are capitalized and depreciated; repairs are deductible current expenses.
- Maintain contemporaneous time logs if you claim material participation or real estate professional status.
- Use Form 4562 to report depreciation and amortization; Form 4797 and Schedule D are used when reporting sales.
Frequent mistakes I see in practice:
- Treating improvements as repairs (or vice versa) without adequate substantiation.
- Missing smaller deductible items (management fees, HOA dues, travel) because of poor document organization.
- Failing to factor depreciation recapture and state tax when modeling the after-tax sale proceeds.
Practical tax planning steps
- Start with clean books: use accounting software and consistent categories.
- Annual review of depreciation schedules; catch missed depreciation early (Form 3115 or amended returns may be needed).
- Consider 1031 exchanges or installment sales timing when planning a disposition.
- Consult a CPA or tax attorney before changing entity structure or claiming material participation.
- Budget for state and local taxes—many states tax capital gains and rental income differently.
Useful resources
- IRS: Real Estate Tax Tips — https://www.irs.gov/businesses/small-businesses-self-employed/real-estate-tax-tips
- IRS Form 4562 instructions (depreciation/amortization) — https://www.irs.gov/forms-pubs/about-form-4562
- FinHelp articles: Depreciation · Depreciation Recapture · Form 4562 — Depreciation and Amortization
Professional disclaimer: This article provides general information about tax rules for U.S. real estate investors and is not personalized tax, legal, or investment advice. Laws and IRS guidance can change. Consult a qualified CPA or tax attorney before making transactions or tax elections.
If you want, I can prepare a one-page checklist for your next property sale or a sample depreciation schedule template to bring to your tax preparer.
