Real Estate Investor Tax Guide — Depreciation, Passive Activity Rules, and 2026 Planning

Rental income is reported on Schedule E and is subject to income tax at the taxpayer's ordinary income tax rate. Rental income is not subject to self-employment tax. Rental losses are generally passive and can only offset passive income, subject to the $25,000 rental real estate allowance for active participants with AGI below $150,000.

The passive activity loss (PAL) rule under IRC §469 limits the deductibility of losses from passive activities (activities in which the taxpayer does not materially participate). Rental real estate is generally treated as passive regardless of participation level (with exceptions for real estate professionals and the $25,000 allowance). Passive losses can only offset passive income — they cannot offset wages, business income, or investment income.

A taxpayer qualifies as a real estate professional if: (1) more than 50% of their personal services during the year are in real property trades or businesses in which they materially participate; and (2) they perform more than 750 hours of services in those activities. If both requirements are met, the taxpayer can treat rental activities as non-passive, allowing rental losses to offset ordinary income.

A 1031 exchange allows a real estate investor to defer capital gains tax by reinvesting the proceeds from the sale of one property into a like-kind replacement property. The investor must identify the replacement property within 45 days of the sale and close on the replacement property within 180 days. The deferred gain is rolled into the basis of the replacement property and is recognized when the replacement property is eventually sold (unless another 1031 exchange is done).

Cost segregation is an engineering study that identifies components of a building that qualify for shorter depreciation lives (5, 7, or 15 years) instead of the standard 27.5 or 39 years. By accelerating depreciation, cost segregation can generate significant tax savings in the early years of ownership. A typical cost segregation study on a $1 million commercial building might identify $150,000-$250,000 of components eligible for accelerated depreciation.

When a rental property is sold, the accumulated depreciation is 'recaptured' and taxed as ordinary income at a maximum rate of 25% (unrecaptured Section 1250 gain). Any remaining gain above the original cost is taxed as long-term capital gain. Practitioners should calculate the depreciation recapture exposure before advising clients to sell rental property.