Depreciation is where it starts
When you buy a rental, you do not deduct the purchase price. You depreciate the building over time: 27.5 years for residential property and 39 years for commercial. The land is never depreciable, so the first job is splitting the purchase price between land and building correctly.
That sounds basic. It is also where a lot of returns go wrong:
- Depreciation never started, so years of deductions were skipped
- The whole price was depreciated, land included
- Improvements were expensed, or never added to the basis
- A property was converted from a home to a rental and nobody reset the basis
Every one of those costs money every single year, quietly.
Watch: Real estate professional status in 2 minutes
The two hour tests, how spouses count, why the time log matters, and who real estate professional status realistically fits.
Own a short-term rental instead? The STR strategy video covers the 7-day rule and the hours tests.
Read the transcript
Own long-term rentals, and spend a lot of your week on real estate? Real estate professional status could change how your rental losses are taxed.
Rental activities are normally passive, so losses generally can't offset your wages or business income. Real estate professional status, or REPS, is one of the main exceptions.
To qualify, you need to pass two hour tests in the same year. First, more than half of your personal working hours must be in real estate trades or businesses where you materially participate.
Second, at least 750 hours in those real estate activities. So, can you qualify with a full-time W-2 job? Usually it's very hard, because your job hours count against that first test.
Qualifying isn't the whole story. You also have to materially participate in the rentals themselves. Many investors file an election to treat all their rentals as one activity, so their hours count together.
Does your spouse count? For married couples filing jointly, only one spouse needs to qualify. For the two hour tests, spouses can't combine their hours. For material participation, they can.
Meet all of it, and rental losses, often driven by depreciation, may offset your W-2 or business income.
The IRS looks closely at these claims, so documentation is everything. Keep a time log as you go, backed up by calendars, emails and records of what you did.
This is for investors where one spouse works in real estate full-time, like an agent, a developer or a full-time landlord, with rentals that produce losses. If you both have full-time jobs outside real estate, it's usually not a fit.
Here's what we'll do for you. We review your hours and your rentals against both tests, show you how to keep a time log that holds up, look at whether the grouping election makes sense, and prepare your return.
What it costs. REPS planning isn't a fixed package, so we'll quote it on the call once we see your facts. Your personal return starts at $600 if you're married filing jointly, plus $250 per rental property on Schedule E. The final price is confirmed after we look at your situation.
On the free discovery call, we look at your numbers, confirm it fits, and you leave with a clear next step and a price. Book yours at nxtlevelcpa.com.
General education, not tax advice for your situation.
Cost segregation
A building is not one thing. Part of what you bought is flooring, appliances, cabinets, lighting, landscaping, fencing and paving. Those pieces have 5, 7 or 15 year lives instead of 27.5 or 39.
A cost segregation study identifies them, which pulls deductions forward into the early years of ownership. Combined with bonus depreciation, the first year deduction can be large enough to change your whole tax picture.
Two things to know:
- Timing matters. The property has to be placed in service in the year you want the deduction. If you are buying in the fourth quarter, talk to us before closing, not after.
- It is not always worth it. The study has a cost, the deductions can be recaptured when you sell, and a large loss only helps if you can actually use it. We run the numbers first.
Missed depreciation can be caught up
If you have owned a rental for years without claiming depreciation, or without a cost segregation study, the deductions are not lost.
The IRS lets you file an accounting method change on Form 3115 and take the entire missed amount as a single catch up adjustment in the current year. No amending old returns. It is one of the most valuable filings in real estate tax, and one of the least known.
Two real examples
Chris and Lauren had two rental properties for years. Nobody ever took depreciation. We filed the paperwork, got back $70,000, and their real estate income is sheltered for years.
Zach did a cost segregation study on his portfolio. It front-loaded his depreciation and generated a $50,000 refund, which he used as the down payment on his next property.
Short term rentals and your W-2 income
Rental losses are normally passive. They can only offset passive income, not your salary. That is why most high earners with rentals see their losses pile up unused.
Short term rentals can be different. If the average guest stay is seven days or less, the property is not treated as a rental activity under the passive loss rules. If you also materially participate, for example by spending more than 100 hours on it and more time than anyone else, the losses can offset W-2 and business income.
This is powerful and it is audited. It only works with:
- A property that genuinely meets the average stay test
- A contemporaneous log of your hours, kept during the year
- Depreciation, often a cost segregation study, set up correctly
Our STR Year-One Setup is $1,500 per property, one time. We check whether the rental qualifies, set up your hours log, decide on cost segregation, put 100% bonus depreciation on your return, and meet with you twice. Buying or opening before December 31? Talk to us before the property is placed in service.
Real estate professional status and other planning
Real estate professional status (REPS)
If you or your spouse spend more than 750 hours a year in real property businesses, and more than half your working time, rental losses can become non passive for long term rentals too. It is a high bar and the IRS checks it, so the time records matter as much as the hours.
The $25,000 allowance
Landlords who actively participate can deduct up to $25,000 of rental losses against other income. It phases out between $100,000 and $150,000 of modified adjusted gross income, which is why many investors think it does not apply to them. Often they are right, and the answer is one of the strategies above.
Buying, selling and 1031 exchanges
Selling triggers depreciation recapture and capital gains. A 1031 exchange can defer both if the timelines are met. Planning the sale before you list is worth far more than cleaning it up after.
These fit into year round tax planning, and broader engagements are scoped after a discovery call.
Rentals in more than one state
Plenty of investors own rentals in more than one state. A rental in another state means a nonresident return there, and the income is also reported on your home state return with a credit. We handle both. See NC and SC dual-state taxes.
Short term rentals also carry sales and occupancy tax obligations that depend on the county and on what the booking platform already collects for you. We check that for each property.
What clients say
“…extremely responsive and very knowledgeable about long term and short-term rental properties. I would definitely recommend him and look forward to working with him again next year!”
“Sargis did my complicated taxes! I really liked the video he made me.”
“Sargis is the exact reason why you hire a CPA to do your taxes versus filing yourself, you don't know what you don't know!”
Questions we get asked
How long do I depreciate a rental property?
Residential rental buildings are depreciated over 27.5 years and commercial buildings over 39 years. Land is never depreciable, so the first step is splitting the purchase price between land and building correctly. Improvements are added to the basis, and a home converted to a rental needs its basis reset when the conversion happens.
What is a cost segregation study?
An engineering based study that breaks a building into components with shorter depreciation lives, such as flooring, fixtures and land improvements. It moves deductions into the early years of ownership instead of spreading them over 27.5 or 39 years. It is not always worth it, because the study has a cost and deductions can be recaptured when you sell.
Can I still claim depreciation I missed in past years?
Yes. An accounting method change on Form 3115 lets you claim the full missed amount as a single catch up adjustment in the current year, without amending prior returns. It applies when depreciation never started or was calculated wrong. It is one of the most valuable filings in real estate tax, and one of the least known.
Can rental losses offset my W-2 income?
Usually not, because rental losses are passive. The main exceptions are short term rentals with an average stay of seven days or less where you materially participate, and real estate professional status. Both need records kept during the year, so we review whether you qualify before the year ends, not after.
Can a 1031 exchange defer tax when I sell a rental?
Yes, if you follow the rules. A 1031 exchange can defer both depreciation recapture and capital gains when you buy like kind real property, identify it within 45 days and generally close within 180 days, with a qualified intermediary holding the cash. Read our 1031 exchange guide.
How much does STR tax help cost?
$1,500 per property, one time, for the STR Year-One Setup. It includes that property's Schedule E, Form 3115 if missed depreciation needs catching up, the qualification check, the hours log, the cost segregation go/no-go and vendor coordination, 100% bonus depreciation on your return, and two strategy meetings. Your 1040 is separate (married filing jointly from $600), so a typical year one for a W-2 couple with one rental is $2,100. A cost segregation study is billed by the study firm. See the STR Year-One Setup.