Real Estate Tax Guide for 2026

How is rental income taxed?

Rental real estate is reported on Schedule E (individual owners and disregarded LLCs) or as part of a partnership 1065 or S corp 1120-S return. Gross rents are reduced by deductible expenses (mortgage interest, property tax, insurance, repairs, management fees, advertising, supplies, professional services, depreciation) to arrive at net rental income or loss.

Rental real estate is generally a passive activity under Section 469. Losses from passive activities can only offset passive income; excess losses are suspended and carry forward, releasing on disposition of the activity.

Two important exceptions narrow passive treatment. Active participation (50 percent ownership and meaningful management decisions) allows up to 25,000 of rental loss to offset non passive income for taxpayers with AGI under 100,000 (phasing out to zero at 150,000 AGI). Real Estate Professional status removes the passive cap entirely.

How does depreciation work on rental property?

Rental real estate depreciates over 27.5 years (residential) or 39 years (commercial) using straight line MACRS. Land does not depreciate; allocate the purchase price between land (typical 15 to 25 percent) and building improvements before computing depreciation. Capital improvements after acquisition depreciate from when placed in service.

Cost segregation studies break the building into component parts (carpet, appliances, land improvements) with shorter lives (5, 7, or 15 years), accelerating early year deductions. Bonus depreciation (60 percent in 2024, 40 percent in 2025, 20 percent in 2026) and Section 179 may apply to short life components depending on whether the property is residential or commercial.

Depreciation is mandatory once a property is placed in service. The IRS treats unclaimed depreciation as having been claimed when calculating gain on sale (the 'allowed or allowable' rule), so failing to depreciate does not avoid recapture.

What is depreciation recapture?

When depreciable property is sold for more than its adjusted basis, gain up to the depreciation taken is taxed differently than the rest of the gain. Section 1250 (real property) caps the depreciation recapture rate at 25 percent. Section 1245 (personal property) recaptures depreciation as ordinary income.

Practical effect for real estate: most rental sales generate gain that has two parts. The depreciation recapture portion is taxed up to 25 percent. The remaining gain (if any) is taxed at long term capital gains rates (0, 15, or 20 percent).

The 25 percent rate is a maximum, not a flat. Lower bracket taxpayers pay their ordinary rate on the depreciation portion if that rate is below 25 percent. Higher earners also pay the 3.8 percent NIIT on top.

How does a 1031 like kind exchange work?

Section 1031 allows deferral of capital gain on the exchange of investment or business real estate for similar real estate (real property only since 2018; personal property exchanges no longer qualify). The exchange must be facilitated by a Qualified Intermediary; you cannot touch the proceeds.

Strict timeline. Within 45 days of selling the relinquished property, identify in writing up to three replacement properties (or more under specific value rules). Within 180 days of selling, close on one or more identified replacements. Both timelines run from the date of the relinquished property sale.

The replacement must be of equal or greater value to fully defer gain. If you take cash (boot) or trade down in value, you recognize gain to the extent of the boot. Mortgage relief is also boot. Plan for boot taxation in advance.

1031 exchanges defer, they do not eliminate. If you sell the replacement without another 1031, all the deferred gain plus any new gain becomes taxable. The strategy effectively works as deferral until death, at which point the heir gets a step up in basis on the inherited property and the deferred gain disappears.

What is the primary residence Section 121 exclusion?

Section 121 excludes up to 250,000 (single) or 500,000 (married filing jointly) of gain on the sale of a primary residence from income, provided the ownership and use tests are met: owned the home and used it as the primary residence for at least 2 of the 5 years ending on the date of sale.

The 2 of 5 year rule does not require contiguous time. A homeowner who lives in a home for 2 years, rents it for 2 years, then sells in the third year of rental still qualifies because they used it as primary for 2 of the prior 5 years.

Partial exclusions are available for sales due to qualifying hardship (job change requiring move of 50+ miles, health, unforeseen circumstances). The exclusion is prorated by the fraction of the 2 year requirement actually met. Form 8332 documents the qualifying reason.

What is real estate professional status (REPS)?

REPS allows rental losses to be treated as nonpassive (deductible against ordinary income). Two requirements must both be met: more than 750 hours and more than half of all personal services performed during the year are in real property trades or businesses, and you materially participate in each rental activity.

The 750 hour and 'more than half' tests apply to the taxpayer (or spouse on MFJ) individually. A spouse who works 40+ hours per week in a non real estate W-2 job almost always fails 'more than half'.

Material participation in each rental is judged by the same 7 tests as any business activity. The aggregation election (Reg 1.469-9) allows treating all rentals as one activity for the material participation test, dramatically easing the burden. Make the election in writing on the return.

How are short term rentals (Airbnb, VRBO) taxed?

Short term rentals (average rental period of 7 days or less) are not Section 469 passive rentals. They are treated as a trade or business if substantial services are provided (cleaning, fresh linens, breakfast), reported on Schedule C and subject to self employment tax. If services are not substantial, reported on Schedule E as non passive rental income.

The 'STR loophole' is real: short term rentals avoid the passive activity loss limit because they are not rentals for Section 469 purposes when the average period is 7 days or less. Material participation rules still apply, but the 750 hour REPS test is irrelevant for short term rentals.

Book the time spent: 100 hours and more time than anyone else, or 500 hours total, are common material participation paths. Document property arrival, cleaning, guest communications, repairs, listing maintenance, and bookkeeping time. With material participation, depreciation and operating losses can offset W-2 income in year one.

What is the qualified business income (QBI) deduction for rental real estate?

Rental real estate may qualify for the Section 199A 20 percent QBI deduction if it rises to the level of a Section 162 trade or business. The IRS published a safe harbor in Rev. Proc. 2019-38 for rental enterprises: separate books and records for each rental enterprise, 250 plus hours of rental services per year, and contemporaneous records of services performed.

Triple net leases (where the tenant pays property taxes, insurance, and maintenance) generally do not qualify because the lessor's services are minimal.

Even outside the safe harbor, a court can find a rental rises to the level of a trade or business based on regularity, continuity, and profit motive. Documentation of involvement (hours, decisions, services provided) supports both QBI eligibility and material participation.

How do I document a rental property purchase for tax purposes?

Keep the closing disclosure (HUD-1 historically). It shows the purchase price, allocations to land and improvements, and any acquisition costs (title insurance, recording fees, transfer taxes) that should be added to basis. Acquisition costs are added to basis, not expensed.

Get a property tax bill that breaks land and improvements separately. This is the strongest evidence for the depreciation allocation. If the tax bill does not split, use the relative ratio (typically 80/20 improvements/land for older urban property; 70/30 or 60/40 for newer suburban; varies wildly by location).

Document any improvements: receipts, contractor invoices, permits. Improvements add to basis and depreciate from when placed in service. Repairs are expensed currently; improvements are capitalized. The de minimis safe harbor allows expensing items under 2,500 dollars per invoice for taxpayers without an applicable financial statement.

What expenses can I deduct on a rental?

Mortgage interest, property tax, insurance, HOA fees, management fees, advertising, repairs, supplies, utilities (if owner pays), professional services (accounting, legal, eviction), travel to the property for management purposes, depreciation, and home office for landlord activities (subject to regular and exclusive use rules).

Travel between rentals or to a single rental for inspection, showing, repair coordination, or supply purchase is deductible. Document with date, destination, mileage, and business purpose. Mixing personal travel with rental visits requires careful proration.

Repairs are immediately deductible. Improvements (extending life, adapting to new use, restoring after major casualty) are capitalized and depreciated. A new roof is an improvement; replacing a leaking section is a repair. The IRS unit of property analysis can complicate the line; default to capitalizing when uncertain.

How does cost segregation affect taxes?

A cost segregation study reclassifies portions of a building purchase into shorter depreciation lives. Components that look like personal property (carpet, appliances, decorative lighting, removable cabinetry, security systems) become 5 or 7 year property. Land improvements (paving, fencing, exterior lighting) become 15 year property. The remaining structure stays at 27.5 or 39 year.

Bonus depreciation applies to property with a recovery period of 20 years or less, which includes everything reclassified through cost seg. So a study at 100 percent bonus depreciation (pre 2023) wrote off 25 to 30 percent of the building cost in year one. With bonus phasing down to 20 percent in 2026, the year one deduction shrinks but is still meaningful.

Cost seg costs 5,000 to 15,000 for a typical rental property study. The deduction generated depends on the property cost, age, and complexity. Rough rule: 1 percent of cost segregation generates 30 to 40 cents of accelerated deduction. The break even point is usually properties of 200,000 dollars and up.

Can I deduct rental losses against my W-2 income?

Generally no, because rentals are passive activities and passive losses only offset passive income. There are three ways to convert rental loss to deduction against ordinary income: active participation under 100k AGI (up to 25k loss allowed), real estate professional status (full active treatment), and short term rental status with material participation (rental is not a 469 passive rental).

If none of these apply, the loss is suspended and carries forward indefinitely until released by passive income or disposition of the rental.

Many high earners with W-2 jobs never qualify for any of these and accumulate suspended losses for years until they sell. The good news: the suspended losses can offset gain on sale, and any remaining suspended losses become deductible against ordinary income in the year of disposition.

What is the home office deduction for landlords?

If you actively manage rentals, the space you use regularly and exclusively for that work qualifies for the home office deduction. The activity must be a trade or business (Section 162), so triple net leases generally do not qualify. Active rental enterprises with substantial owner involvement do.

The deduction reduces rental income on Schedule E. Use either the simplified method (5 dollars per square foot, up to 300 square feet) or actual expenses (Form 8829, prorated by business percentage of square footage).

The home office becomes one of multiple factors supporting Section 199A QBI eligibility (showing the rental rises to a Section 162 trade or business). Document time, decisions, services, and receipts.

How do property tax and mortgage interest interact with the SALT cap?

The Tax Cuts and Jobs Act capped state and local tax (SALT) deduction at 10,000 dollars for individuals. This cap applies to state income tax plus property tax. Most real estate investors hit it because their state income tax alone uses up most of the cap.

Mortgage interest is a separate itemized deduction, not part of SALT. It is limited to interest on up to 750,000 of acquisition debt on a primary residence and one second home (1 million for loans before December 15, 2017).

Rental property mortgage interest and property tax are deducted on Schedule E against rental income, not on Schedule A. They are not subject to the SALT cap and not subject to the 750k mortgage interest limit. The limits apply only to personal residence interest and personal property tax.

Where can I get specific advice?

For real estate tax preparation and planning, contact Amanda directly. The Planning membership at 125 per month covers ongoing real estate strategy: cost segregation timing, 1031 planning, REPS qualification, STR strategy, and disposition planning. Financial Partnerships at 1,000 to 3,000 per month cover larger portfolios with multiple entities and continuous involvement.

Free authoritative sources: IRS Publication 527 (residential rental property), Publication 925 (passive activity and at risk rules), Publication 587 (business use of your home), Publication 544 (sales and other dispositions of assets), Publication 551 (basis of assets).

For 1031 exchanges, only use a Qualified Intermediary. Asset Preservation, Inc., Investment Property Exchange Services, IPX1031, and Old Republic Exchange are major national QIs. Local title companies often partner with QIs.