Real estate can be an effective way to diversify an investment portfolio, generate rental income and build wealth over the long term. For many investors, however, real estate is not their primary business or occupation. Instead, they own anything from a single rental home or condominium to multifamily properties or commercial real estate as a secondary source of income.
Regardless of the type of property you own, real estate investing comes with important tax considerations. Understanding the rules and planning ahead can help you make better investment decisions and potentially increase your after-tax returns.
Rental Activity Rules
One of the first issues real estate investors should understand is how the tax law treats rental income and losses.
Generally, rental activities are considered passive activities for tax purposes unless you qualify as a real estate professional. Even if you meet the real estate professional requirements, you generally must also materially participate in a rental activity for it to be treated as nonpassive.
Why does this distinction matter?
Passive income may be subject to the 3.8% net investment income tax (NIIT) in addition to regular income tax. At the same time, passive losses generally can be deducted only against passive income, with unused losses carried forward to future years.
For someone whose primary career is outside the real estate industry, qualifying as a real estate professional can be challenging.
To qualify, you generally must meet two requirements each year:
- More than 50% of the personal services you perform must be in real property trades or businesses in which you materially participate.
- You must perform more than 750 hours of service during the year in those real property trades or businesses.
The tests apply separately each year, and additional rules can affect how the requirements are applied.
Understanding Material Participation
Material participation is another important factor when determining whether rental activity is passive or nonpassive.
Generally, you may satisfy the material participation requirement by participating in an activity for more than 500 hours during the year or by demonstrating that your participation represents substantially all of the participation in the activity. Several other tests may also allow you to qualify.
Because these requirements depend heavily on the amount of time you spend on various activities, keeping detailed records is important.
If you own rental properties while also working in another business or profession, track the time you spend on both. This can help you determine whether the time devoted to your non-real-estate work is sufficiently limited for you to potentially satisfy the real estate professional requirements.
Your spouse’s participation can also be relevant. Although your spouse’s hours generally cannot be used to satisfy your own real estate professional tests, special rules allow your spouse’s participation to be considered when determining whether you materially participate in an activity.
Take Advantage of Depreciation Opportunities
The purchase of an investment property is often only the beginning of the costs involved. Renovations, improvements and other expenditures can significantly increase your investment, and the tax treatment of those costs depends on the nature of the property and the improvements.
Generally, residential rental property is depreciated over 27.5 years, while commercial real estate is generally depreciated over 39 years.
However, real estate investors may have access to several valuable depreciation-related tax breaks.
1. Qualified Improvement Property (QIP)
Qualified improvement property generally refers to improvements made to the interior portion of a nonresidential building after the building was originally placed in service.
This means QIP rules can apply to certain improvements made to commercial real estate, but generally not to improvements made to residential rental properties.
Qualifying QIP has a 15-year Modified Accelerated Cost Recovery System (MACRS) recovery period and may qualify for bonus depreciation and Section 179 expensing.
There are important exceptions. For example, costs related to enlarging a building, installing elevators or escalators, or modifying a building’s internal structural framework generally don’t qualify as QIP. These expenditures typically must be depreciated over 39 years.
2. Bonus Depreciation
Bonus depreciation provides an additional first-year depreciation deduction for qualifying assets, including eligible QIP.
For eligible property acquired and placed in service after January 19, 2025, the bonus depreciation rate is 100%.
This can provide a significant upfront tax benefit for investors who make qualifying improvements or purchase other eligible assets.
3. Section 179 Expensing
The Section 179 election allows businesses to immediately deduct the cost of certain qualifying property, subject to applicable limitations.
For real estate investors, qualifying property can include QIP and certain depreciable tangible personal property used predominantly to furnish lodging. Certain improvements to nonresidential real property may also qualify, including:
- Roofs
- Heating, ventilation and air-conditioning (HVAC) equipment
- Fire protection and alarm systems
- Security systems
For 2026, the maximum Section 179 deduction is $2.56 million. The deduction begins to phase out when the total cost of qualifying property placed in service during the year exceeds $4.09 million.
Because depreciation and expensing rules can be complex, investors should evaluate these options before completing major property improvements or purchases.
Consider Strategies for Deferring Taxable Gains
At some point, you may decide to sell a rental property or another real estate investment that has appreciated significantly.
Depending on the circumstances, you may be able to structure the transaction to defer some or all of the taxable gain. In certain situations, tax-deferral strategies may also help keep your income low enough to avoid or reduce exposure to the 3.8% NIIT and the 20% long-term capital gains tax rate.
Two strategies worth considering are installment sales and Section 1031 exchanges.
Installment Sales
An installment sale can allow you to spread taxable gain over several years as you receive payments from the buyer rather than recognizing the entire gain in the year of the sale.
However, there is an important exception to keep in mind. Ordinary income resulting from certain depreciation recapture generally must be recognized in the year of the sale, even if you haven’t yet received all of the sale proceeds.
Section 1031 Exchanges
A Section 1031 exchange, commonly known as a like-kind exchange, can allow you to exchange one investment real estate property for another while deferring tax on qualifying gain.
Instead of immediately recognizing the gain from the property you give up, the tax generally can be deferred until the replacement property is eventually sold.
There are specific requirements that must be met to qualify. In addition, if you receive cash or other property that isn’t like-kind as part of the transaction, you generally must recognize gain to the extent of that amount.
Understand the Risks of Tax Deferral
Tax-deferral strategies can be valuable, but they aren’t necessarily appropriate in every situation.
For example, deferring a gain doesn’t permanently eliminate the tax. If tax rates increase in the future, you could ultimately pay more tax when the deferred gain is recognized.
Installment sales and Section 1031 exchanges also have detailed requirements and deadlines. Before selling or exchanging an investment property, it’s important to evaluate the tax consequences and determine whether the strategy makes sense for your overall financial situation.
Make Tax Planning Part of Your Real Estate Strategy
Taxes can influence the financial results of an investment property at virtually every stage — from the initial purchase and improvements to the eventual sale.
How you participate in rental activities, how you handle property improvements, and when and how you sell an investment property can all have significant tax consequences.
Proactive tax planning can help you identify potential tax-saving opportunities while avoiding costly mistakes.
If you own rental or investment real estate, contact us to discuss your tax planning options. We can help you evaluate the tax implications of your real estate investments and develop strategies designed to improve your after-tax results.
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