By Jason Watson, CPA
Posted Sunday, April 5, 2026

As of the 2026 tax year, most states still treat rental real estate in a fairly ordinary way: the income lands on Schedule E, flows to the state tax return, and life goes on. Yay! However, the states below are the ones worth flagging because they can impose an entity-level tax, a gross-receipts-style tax, or a separate business filing regime that goes beyond the usual set it and forget it approach.

A lot of the issues below arise because of owning and operating your rental property through an LLC, even those that are single-member and considered disregarded for tax purposes. We have a comparison table coming up in a bit.

Alabama

Alabama is another state where an LLC itself can create a separate tax problem even when the federal tax return stays simple. The Alabama Department of Revenue says every corporation, limited liability entity, and disregarded entity doing business in Alabama or organized there must file an Alabama Business Privilege Tax return, so the trap is the entity-level filing and tax regime rather than the rental income itself.

California

California is the cleanest example of an LLC trap state. If an LLC is organized in California or is doing business there, California generally imposes its $800 annual franchise tax, and LLCs with enough California gross rental revenue, regardless of profits, can also face an additional LLC fee. This means a disregarded single-member LLC is not ignored for state-level cost purposes the way it is for federal income tax purposes.

District of Columbia

D.C. is a trap jurisdiction because the filing regime is broader than many people expect. D.C.’s D-30 framework can treat rental or leasing activity as a “trade or business,” particularly when the activity rises above a passive investment level. The District has also issued guidance directing some rental property owners to prepare a D-30 using Schedule E figures, so this is not a jurisdiction to casually hand-wave away as “just passive rent.”

Hawaii

Hawaii is one of the most important activity-based states because its General Excise Tax (GET) applies to business activity, including the renting of real property, and it is imposed on gross income, not net rental profit. In other words, this is not just another income-tax state; Hawaii can add a separate tax layer to rental activity whether the property is owned personally or through an LLC.

New Hampshire

New Hampshire is not a pure bright-line state. While it does have clear income thresholds for its Business Profits Tax (BPT) and Business Enterprise Tax (BET), those thresholds only apply after you determine whether your rental activity rises to the level of a trade or business. That initial determination is based on facts and circumstances such as the level of activity, number of properties, and degree of management, and not a simple rule.

In practice, a single long-term rental may remain outside the business classification, while multiple properties or short-term rental activity can push the owner into New Hampshire’s business tax regime, where the statutory thresholds then control whether a filing and tax are required.

Messy. New Hampshire gets three paragraphs.

New Mexico

New Mexico is often flagged because of its gross receipts tax (GRT), which applies broadly to business activity, including leasing property. However, long-term residential rentals are generally carved out through a deduction mechanism, meaning most traditional rental properties are not subject to GRT. That said, short-term rentals are a different story. Shocker, right? Rentals with an average guest stay of fewer than 30 days (not 30 days or less) are treated as a taxable business activity, and the gross receipts are subject to GRT (along with potential local lodging taxes as you would expect). In other words, New Mexico is mostly a non-issue for long-term rentals, but it becomes a true gross receipts tax state once you cross into short-term rental territory.

New York

New York is less dramatic than California, but it is still a classic nuisance state for rental LLCs. A disregarded LLC with New York-source income is subject to the annual IT-204-LL filing fee, so the property may be “disregarded” federally while still creating a separate state filing obligation. For the 2025 tax year, the tax imposed for a single-member LLC is $25, but for multi-member LLCs (including those owned by spouses), the fee can increase significantly based on income levels.

Tennessee

Tennessee gets two paragraphs. Tennessee adds another layer of nuance because of its Franchise & Excise tax regime and the Family-Owned Non-Corporate Entity (FONCE) exemption. Long-term rental activity is generally treated as passive investment income and often qualifies for the exemption, meaning a FAE170 filing is not required.

However, short-term rentals can blur that line. As rental activity becomes more operational such as frequent tenant turnover, platform-based bookings, and added services, it begins to resemble a trade or business rather than passive investment. When that happens, the FONCE exemption may no longer apply, and the entity can become subject to Tennessee’s franchise and excise taxes.

The key is not the label “short-term rental,” but the level of activity behind it. It’s a bummer since Tennessee is a current hotspot for short-term rental investors, especially in the Smoky Mountains (Gatlinburg, Pigeon Forge, Sevierville), with strong year-round tourism. So, here’s to you unsuspecting real estate investor, be careful in Tennessee.

Texas

Texas is more filing-burden than tax-burden for many smaller landlords, but it still belongs on the list. For the 2026 report year, the no-tax-due threshold is $2.65 million, and entities below that threshold generally owe no franchise tax, but still have annual filing requirements. However, Texas eliminated the “No Tax Due” report beginning in 2024 and replaced it with a requirement to file a Public Information Report (PIR) or Ownership Information Report (OIR). In other words, even when no tax is owed, the LLC is still expected to file annually, creating compliance friction without a corresponding tax liability.

Washington

Washington is a strong reminder that the line between a rental activity and a business can matter more than the ownership structure. The Department of Revenue says renting or leasing real estate is generally not subject to B&O tax, but income from granting a license to use real property is subject to B&O tax, which is why shorter-term or hotel-like arrangements deserve a much closer look than ordinary long-term residential rentals.

Key Takeaways For State Tax Return Complexity

Here are some takeaways for your ruminating pleasure-

• Most states are still boring. In most states, rental real estate remains a Schedule E story, not a separate state business-tax story. Form 8825 filings with partnership tax returns are a whole different ball of wax.
• Some states punish the LLC, not the rental. California, New York, Alabama, and often Texas impose extra entity-level filing or tax burdens that exist because the LLC exists, even if the rental itself is otherwise uneventful.
• Some states care more about the activity than the entity. Hawaii, Washington, and D.C. are the main examples where the nature of the rental activity can matter as much as, or more than, the ownership structure (owning personally or within a single-member LLC).
• Short-term rentals deserve extra suspicion. A state that leaves a plain-vanilla long-term rental alone may treat a short-term rental as something much closer to an operating business.
• A “flagged state” above does not always mean tax is automatically due. Tennessee, D.C., and New Hampshire are good examples of states where the real issue is that you need to stop, analyze the facts, and confirm whether an exemption, threshold, or separate filing rule applies.
• This section should age as a warning, not a checklist. The evergreen lesson is not to memorize these forms forever; rather it is this- if your rental touches one of these states, slow down and dig into the state-specific rules.

Here is a table that is jam-packed and spans two pages. Good luck.

State	LTR	STR	LTR w/ LLC	STR w/ LLC	Notes
Alabama	No	No	Yes	Yes	Business Privilege Tax applies to LLCs / disregarded entities doing business in Alabama.
California	No	No	Yes	Yes	$800 annual LLC tax, plus additional LLC fee at higher California gross rental revenue levels.
District of Columbia	No*	Yes	No*	Yes	D.C. UBT is the concern for active rental activity; traditional passive LTRs are usually the safer lane, while STRs are more likely to look like a business.
Hawaii	Yes	Yes	Yes	Yes	General Excise Tax (GET) is activity-based and can apply to rental receipts broadly.
New Hampshire	No*	No*	No*	No*	Hybrid state: first ask whether the rental rises to a business activity (facts and circumstances), then apply thresholds.
New Mexico	No*	Yes	No*	Yes	GRT is broad, but long-term residential rentals are generally removed through a deduction mechanism; rentals of less than 30 days are treated as taxable short-term lodging / vacation rental activity.
New York	No	No	Yes	Yes	IT-204-LL filing fee for disregarded LLCs with New York-source income.
Tennessee	No	No	Yes*	Yes*	FAE170 risk sits at the LLC level, but the FONCE exemption can remove passive, family-owned activity from the tax. Tennessee says substantially all activity must be passive investment income (or passive plus farming), and its guidance says some short-term vacation rentals may still qualify as passive depending on structure and activity level. So STRs are riskier, but not automatically taxable.
Texas	No	No	Yes*	Yes*	Mostly filing friction, not tax friction, for smaller landlords. Texas eliminated the old No Tax Due Report, but entities below the threshold still generally file a PIR or OIR annually.
Washington	No	Yes	No	Yes	B&O issue is mainly with STR / license-to-use activity; traditional LTRs are generally exempt.

* Please see prior narrative for additional information.

By Jason Watson, CPA
Posted Sunday, April 5, 2026

Owning rental property in another state creates more than just cash flow- it creates tax jurisdiction. Great, what does that mean? It means that even if your rental activity shows little or no taxable income (i.e., a tax loss), that state, and more correctly, that taxing jurisdiction, generally has the right to inspect your books and records to validate your net tax effect and, just as importantly, to revisit it later. Woah, that’s a long sentence.

The real question, then, is not always whether you owe tax today, but whether you should be filing anyway. In many cases, the answer is yes. Not because of the current year’s result, but because of what the state tax return filing does for you over time.

Controlling The Tax Narrative

When you own income-producing real estate in a state or even a city, you are generally considered to have nexus there simply based on the asset’s physical presence. Filing a non-resident state tax return acknowledges that relationship and establishes a clean, defensible reporting position. If you don’t file, you are not avoiding attention- you are simply leaving the state to fill in the blanks later, and states tend to fill in blanks.

Sidebar: As with any missing information in life, others will substitute their own assumptions. They are usually wrong, and usually in their favor. And why not? You’d probably do the same thing

There is also a practical consideration that often gets overlooked: in most states, the statute of limitations does not begin until a tax return is filed. No filing can mean no time limit on audit exposure, which is rarely a position you want to be in.

When State And Federal Tax Rules Diverge

Beyond audit posture and narrative position, the more technical reason to file comes down to how states diverge from federal tax law. As you might have learned from a previous section, many states do not follow federal rules on bonus depreciation, Section 179, or even certain passive activity concepts.

California is the most commonly cited example, but it is far from alone. When a state decouples from federal rules, you are no longer working with a single set of numbers. You now have a federal depreciation schedule and a separate state depreciation schedule, whether you realize it or not, along with potentially different passive loss carryforwards. Filing annually allows those differences to be tracked cleanly as they occur. Without that annual reporting, you are left trying to reconstruct years of adjustments later, which is both time-consuming and prone to error.

And it doesn’t stop there, oh no sir, depreciation (basis) and loss carryforwards add another layer.

Protecting Your Cost Basis For The Future Sale

This leads to one of the most important and most overlooked issues: basis tracking for future sale. Because many states limit or disallow accelerated depreciation, your state basis is often higher than your federal basis. That difference works in your favor. A lower federal basis typically results in a higher federal gain, while a higher state basis results in a lower state gain. This makes sense, but is often missed or skipped during rental property dispositions. Especially when no state filing history exists to support the difference.

In other words, you may end up paying less tax to the state when the property is sold. But that benefit only exists if you can support it. If you have not been filing state income tax returns, your state-specific depreciation adjustments might not be properly documented.

Why is this a big deal? Many states require that the federal tax return is filed alongside the state tax return, or at least pertinent portions of it. This gives visibility into the calculated gain on your rental sale from your federal tax return as compared to your state tax return. If you suddenly show a discrepancy without building that history over the years, the state tends to take issue with it. The result is that you could actually overpay state tax on the sale simply because the history was never established.

Preserving Suspended Losses

Passive activity loss carryforwards present a similar issue. Even when rental losses are clear at the federal level, states often require filed returns to establish and preserve those losses on their terms using their forms. Also, going back to the issue about books and records, states that accept your losses through consistent filings have less room to challenge them later when those suspended losses are released upon sale.

All in all, and without a filing history, suspended losses may be limited, delayed, or challenged outright. What appears to be a simple “paper loss” today can become a contested issue later if it was never properly reported at the state level.

The Administrative Snowball Effect

There are also practical, administrative considerations that come into play over time. State-level withholding requirements, particularly upon disposition, can create mismatches if prior filings do not exist. What are we talking about here?

Many states require title companies to withhold state income taxes often based on the gross sale amount. This in turn requires you to file a non-resident tax return just to get your tax refund. This too can present challenges from the state if your historical data doesn’t align.

When It Might Make Sense To Skip Filing State Tax Returns

To be fair, and equal opportunity provider, there are situations where filing a non-resident tax return may not be necessary. Minimal income, clear statutory exemptions, or situations where the administrative burden truly outweighs the benefit can justify a different approach. But that should be a conscious decision, not a default assumption.

Who Wants To Pick On California

Everyone? Awesome. Consider a simple example. You own a rental property in California while living in another state. Federally, you take bonus depreciation and generate a large loss. California does not allow bonus depreciation and Section 179 didn’t make sense either, so your California loss is smaller and your depreciation is spread out over a longer period.

Over time, your federal basis declines faster than your California basis. When you eventually sell the property, the federal gain is larger, and the California gain is smaller.

Moreover, California does not conform to federal real estate professional status (REPS) and losses allowed under IRC Section 469 (as we discussed in our state problems with your rental property section on page 138). As such, not only is your basis different, your passive losses that are carried forward are different as well, and in some cases, California’s will be much higher.

Said differently, you could have a small gain simply because of depreciation allowance and even a smaller gain because of higher passive losses that are released upon sale.

Net Net On State Tax Returns

The bottom line is that filing a non-resident return for a rental property is rarely about the current-year tax bill. It is about establishing a record, tracking state-specific differences, preserving your basis, and protecting future outcomes. That is literally on California’s 540NR. Kidding.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Part 5 of our miniseries focuses on the “Bank of You.” In a real estate market occasionally (and perhaps stubbornly) defined by high interest rates and tight lending standards, seller financing (sometimes called carryback financing) always makes a comeback. Instead of the buyer going to a traditional bank for a mortgage, they come to you. You accept a down payment and a promissory note for the balance.

The appeal is obvious. You can sell a property that might otherwise sit stagnant on the market, and you earn interest income that is often higher than a standard savings account. More importantly, you get tax deferral. Instead of paying all your capital gains tax in year one, you pay it slowly over the 10, 20, or 30 years you receive payments.

Sidebar: In any installment sale scenario, we recommend a 5-year balloon or perhaps a 10-year. Let banks be banks. Your installment generosity was mostly to grease the skids and get this deal closed. Long-term financing brings long-term risk.

It sounds like the perfect plan, right? But there are massive traps buried inside IRC Section 453 that can leave you cash-flow negative or heavily tax-exposed.

Trap #1: The Recapture Cash Call

This is the rule that leaves unsuspecting sellers frustrated like the Monopoly guy with empty pockets. Depreciation recapture is entirely ineligible for installment sale reporting. Wait! What? Yeah, you read it correctly.

The general rule of installment sales is that you recognize gain pro-rata as you receive cash. Simple. If you receive 10% of the sale price, you pay tax on 10% of the gain. However, the IRS makes a glaring exception for our old friend, depreciation recapture.
Who wants some code? Let’s look at IRC Section 453(i)(1), specifically dealing with the recognition of recapture income in the year of disposition:

(1) In general
In the case of any installment sale of property to which subsection (a) applies—
(A) notwithstanding subsection (a), any recapture income shall be recognized in the year of the disposition, and (B) any gain in excess of the recapture income shall be taken into account under the installment method.

See that phrase “recognized in the year of the disposition”? That means certain depreciation-related gains must be recognized immediately in the year of sale, even if you receive very little cash. This typically includes depreciation from personal property, cost segregation components, Section 179 expensing, or other accelerated depreciation. Because these amounts are treated as ordinary recapture income, they cannot be reported using the installment method.

Sidebar: Recapture vs. Unrecaptured Gain True IRC Section 1250 recapture, which is uncommon for modern residential rentals depreciated using straight-line methods, also cannot use the installment method. This is very different from unrecaptured Section 1250 gain, which is the standard 25% tax bucket common in rental real estate. Unrecaptured Section 1250 gain can follow the installment method for gain recognition, allowing you to defer those taxes over the life of the note. Yawn.

Consider this nightmare scenario:

• You sell a property for $1,000,000. You take a $50,000 down payment and hold a $950,000 note. Yeah, unlikely, but stay with us.
• You have owned the building for 20 years and have $200,000 of accumulated depreciation (recapture).
• The IRS deems you to have received the full $200,000 of recapture income immediately.

If we assume a 25% combined state and federal tax on that $200,000 recapture, your tax bill is $50,000. If you also have $60,000 in selling costs and commissions, you have a massive problem. You received $50,000 in cash from the buyer, but you wrote checks for $110,000 (tax on recapture and selling costs). You are negative $60,000 on the deal. You handed over the keys to your building and had to write a check to the IRS for the privilege. Yuck!

Ok, to be fair this is an extreme example especially considering the super low down payment above. However, there is still a cash crunch created by all depreciation recapture coming in on year 1.

Trap #2: The Anatomy Of A Payment

Many sellers mistakenly believe that the monthly check they receive is fully taxable. Others think it is tax-free until they recover their original cost basis. Both are wrong. Every payment you receive is split into distinct buckets for tax purposes.

• First, you have interest income, which is taxed at your ordinary income rates (up to 37%).
• Then, the principal portion of the payment is split again. A portion is a tax-free return of your basis (your original investment or capital coming back to you), and
• the rest is capital gain, taxed at preferential rates.

To determine the exact split of that principal payment, you must calculate your Gross Profit Ratio. IRC Section 453(c) defines the installment method perfectly:

(c) Installment method defined For purposes of this title, the term “installment method” means a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.

As such, if you bought a property for $100,000 and sold it for $300,000, your gross profit is $200,000. Your gross profit percentage is 66.67%. Therefore, for every $1,000 of principal you receive, about $333 is tax-free return of basis and about $667 is taxable gain. Does $334 and $666 sound better?

Also, beware the high interest mirage. Earning 8% interest on a carryback note sounds fantastic, but remember that interest is ordinary income. It does not enjoy capital gains tax rates. If you are a high earner, your after-tax yield on that 8% note might be significantly lower than you anticipate. Then again, 8% in our example, is not too far off most people’s cost of equity (9 to 11% for most taxpayers).

Trap #3: The Imputed Interest Rule

Sometimes, a seller tries to be nice to a buyer (often a child or family member) by charging 0% interest or a drastically below-market rate. They structure the deal entirely as principal payments to avoid ordinary income tax on the interest.

The IRS hates interest free loans since there is no such thing as a free lunch, and anyone offering something for free is making it up elsewhere. Under the imputed interest rules, the IRS can recharacterize part of your deferred payments as interest if the note does not provide for adequate stated interest. This minimum rate is known as the Applicable Federal Rate, or AFR.

IRC Section 483(a) reads-

(a) Amount constituting interest For purposes of this title, in the case of any contract for the sale or exchange of property there shall be treated as interest that portion of the total unstated interest under such contract which, as determined in a manner consistent with the method of computing interest under section 1272(a), is properly allocable to such payment.

When the IRS imputes interest, they forcibly reclassify a portion of your principal payments as interest. You are required to pay ordinary income tax on money you thought was capital gains (or tax-free basis), even though you didn’t actually charge the buyer a lick of interest.

The Foreclosure Risk (Section 1038)

Finally, what happens if the buyer defaults? You get the property back. That sounds okay, right? You keep the down payment and get the building back.

Under IRC Section 1038, repossessing real property can trigger taxable gain, even though the seller generally does not recognize a loss. While you generally don’t recognize loss, you must recognize gain to the extent of the cash payments you already received prior to the repossession that haven’t already been taxed as gain. Huh?

The real sting? You do not get a refund for the taxes you paid on the sale in year one (like that massive recapture tax). That money is gone. You now own the property again, but your bank account is lighter by the amount of tax you paid to the IRS.

Want some good news? Your basis in the property resets. Under IRC Section 1038, your new basis becomes the basis of the defaulted note, plus the gain you just recognized on repossession, plus your legal fees to get the property back (think acquisition costs). Because you already paid that massive recapture tax and recognized gain on the cash received, your starting basis is stepped up. If you redeploy the property as a rental, you get to start depreciating it all over again based on this new, higher number.

Mortgage Exceeds Adjusted Basis

That heading alone can make you drool. But the warning remains- if the property you are selling still has a mortgage loan, the installment method can behave strangely. If the buyer assumes your mortgage, the IRS does not automatically treat that debt relief as cash unless that debt exceeds your adjusted basis in the property. If your mortgage is higher than your basis (often due to cash-out refinances or heavy depreciation), the IRS treats that excess amount as cash received in the year of sale. In extreme cases, sellers can owe a massive tax bill in year one despite receiving almost no actual money at closing.

Seller financing is a powerful tool to free up equity in a frozen market. But it turns you into a bank, and banks have complex accounting departments for a reason. Calculate your recapture first, respect the AFR, and heavily vet your buyer.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Part 4 of our series tackles the messy intersection of home and business when it comes to capital gains. As most real estate investors know, there is a $250,000 exclusion for single taxpayers and $500,000 exclusion for married taxpayers on the gains attributed to the sale of a primary residence.

Rental Was Your Primary Home

According to IRC Section 121, there are two tests-

• Owned the home for at least two years (the ownership test), and
• Lived in the home as your main home for at least two years of the past five years (the use test)

The ownership and use test do not have to overlap (you could rent a home for two years, purchase it, convert to a rental, and sell two years later and still be eligible for the gain exclusion). Additionally, the two years do not have to be consecutive. The best way to compute or think about this is to consider months as your unit of measurement- 24 out of 60. This helps with fragmented ownership and use periods.

There are several exceptions for health, work-related move, unforeseen circumstances, death, divorce, government personnel on extended duty (think military) among others. We will not go into these, however, since IRS Publication 523 Selling Your Home has nauseating details and examples.

But what happens when you have a hybrid home where your property was part home and part rental? When we have a single structure that was used as both at different times, you must consider the period of non-qualified use, which might limit how much of the gain is excluded. According to IRC Section 121(b)(5)(C)–

The term “period of nonqualified use” means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.

There are two basic scenarios with varying outcomes when you sell a property that was both a rental and your primary residence-

• The property was a rental first, and then you occupied the property as your primary residence.
• The property was your primary residence first, and then you converted it into a rental.

The immediate perspective on these scenarios is that you can influence the tax effects by the time spent living in the property as your primary residence. In other words, delaying a sale to increase the time spent as a primary residence might prove beneficial.

Let’s run through these two examples-

The first example involves some math since a portion of the gain is not excludable because of nonqualified use. This is because the property was not used as a primary residence for a portion of the ownership period that counts as “nonqualified use” under the tax code. This contrasts with the thought that the amount of exclusion is reduced. Huh?

In other words, the tax code when written could have either reduced the amount of the exclusion or it could have limited the amount of gain eligible for exclusion. Again, subtle difference. The good news is that as written, IRC Section 121 limits the amount of gain eligible for exclusion which is a loophole of sorts or perhaps a version of tax arbitrage.

Consider-

Gain on Property Sale (a)	650,000
Years of Non-Qualified Use	3
Years of Total Ownership	12
Percentage (b)	25%
Non-Excludable Gain (a x b)	162,500
Excluded Gain under IRC Section 121	487,500

The above example is how the law works assuming married taxpayers. But what if the exclusion amount of $500,000 was reduced by the period of non-qualified use? You would have this-

IRC Section 121 Gain Exclusion	500,000
Gain Exclusion Reduction (fictitious)	125,000
Adjusted Gain Exclusion (fictitious)	375,000
Illustrative Difference	112,500

In our fictitious second example, $112,500 would not be excluded because the exclusion amount was reduced (versus reducing the amount of gain that is eligible for exclusion). Yes, this is a bit nerdy, but it matters. Sorry, not sorry. The fauxpology.

Neat. Let’s move on to the second scenario where the property was your primary residence first, and then you converted it into a rental. IRC Section 121(b)(5)(C)(ii)(I), yeah deep deep deep into the code, reads-

(ii) Exceptions. The term “period of nonqualified use” does not include-
(I) any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse,

What does this mean? If you owned a property for five years, and for the first three years it was your primary residence, the period afterwards is not included as a “period of nonqualified use.” In other words, rental use after the last use as a primary residence is ignored only if the property still meets the “2-of-5 test.” Therefore, you would enjoy the full gain exclusions of $250,000 (single) or $500,000 (married).

But not so fast! What about depreciation recapture? Depreciation recapture is not excludable. Ah, we just buzz-killed the topic, didn’t we?

Here is an example of a hybrid-use property (rental and primary residence) where the eligible gain is reduced plus depreciation recapture-

Or

Original Purchase Price (cost basis)	500,000
Depreciation Taken	75,000
Adjusted Cost Basis (a)	425,000
Sale Price (b)	675,000
Preliminary Gain (b – a)	250,000
Depreciation Recapture	75,000
Remaining Gain to Be Considered (c)	175,000
Years of Non-Qualified Use	3
Years of Total Ownership	12
Percentage (d)	25%
Non-Excludable Gain (c x d)	43,750
Excluded Gain under IRC Section 121	131,250

In this example, the property owner will pay-

• Ordinary taxes (taxed at up to 25% as unrecaptured Section 1250 gain) on the depreciation recapture of $75,000, and
• Long-term capital gains taxes on the $43,750.

The big takeaway is the ability to influence some of the math with how much time is spent using the property as your primary residence. Tax planning is a must.

Separate Structure Gains Exclusion

You are not going to be thrilled with this. Let’s say you have an ADU alongside your primary residence and you later sell. A portion of the sale price certainly includes the ADU, right? Can that gain be excluded under IRC Section 121? The answer is generally No. IRS Publication 523 Selling Your Home reads in part-

Space separate from the living area.
You generally can’t exclude gain on the separate portion of your property used for business or to produce rental income. Regulations section 1.121-1(e) provides that the use of a separate portion of your home for business or rental purposes doesn’t qualify for exclusion under section 121, and this may affect your gain or loss calculations. See Regulations section 1.121-1(e). Examples are:

• A working farm on which your house was located,
• A duplex in which you lived in one unit and rented the other, or
• A store building with an upstairs apartment in which you lived.

You can’t exclude gain on the separate part of your property used for business or to produce rental income unless you owned and lived in that part of your property for at least 2 years during the 5-year period ending on the date of the sale. If you don’t meet the use test for the separate business or rental part of the property, an allocation of the gain on the sale is required. For this purpose, you must allocate the basis of the property and the amount realized between the residential and nonresidential portions of the property using the same method of allocation that you used to determine depreciation adjustments.

Yuck! What can be done? Most people default to square footage, but this usually overestimates the value of the rental since a 500 sqft ADU rarely contributes value equal to a 500 sqft luxury living room in the main house. Instead, use a relative fair market value strategy. You would need to obtain an appraisal or broker’s opinion showing a purchase price allocation based on relative fair market value (and hopefully where very little is being assigned to the ADU, right?).

For example, if the property sold for $1M, you argue the main house is valued at $920,000 and the ADU contributes only $80,000. As a result, only 8% of the gain is allocated to the taxable rental portion, rather than 20% based on size. Recall from our earlier discussion on purchase price allocations and the underlying tone of fair market value viewed independently. The concept is the same here.

And remember, any depreciation claimed on the rental portion must still be recaptured, even if part of the gain qualifies for the primary residence exclusion under IRC Section 121. Many people get trapped on this thinking the exclusion excludes depreciation recapture.

The ADU example is easy, right? The duplex one is way more obnoxious. If you buy a duplex for $250,000 and rent one half to others, and then later sell for $600,000, you will have some problems. The overall gain is $350,000 in this example, but a portion must be assigned to the separate portion of the property for rental purposes. A tiny argument could be made for upgrades. If the primary half has granite counters and hardwood floors while the rental half has laminate, you can argue a larger portion of the $600,000 sales price is associated with the “good” half. Then again, upgrades or improvements add to the overall cost basis, naturally lowering your gains. Be careful not to accidentally lower your gain on the tax-free side while leaving the taxable rental side high (assuming a 50-50 split). Lots of hairs to split.

Did we happen to mention fair market value? If not, we are mentioning it (again).

By Jason Watson, CPA
Posted Monday, March 30, 2026

The good news is you finally get to use those old suspended losses to wipe out income. Flip the coin over, and you might get hit with a 3.8% surtax called NIIT.

Here we go with part 3 of our miniseries on selling your rental property.

Passive Activity Losses Upon Disposition

If you have been a landlord for a while, you are likely familiar with Form 8582. This is where unallowed passive activity losses go to hibernate. And they usually get fatter each year.

All is not lost, however. The IRS sums this up nicely in Topic No. 425, Passive Activities – Losses and Credits by stating, “Generally, you may fully deduct any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity.” To trigger this release, you must dispose of your entire interest in the property in a fully taxable transaction to an unrelated party. By the way, businesses that you control are related parties. Bummer.

First, the suspended losses become fully deductible and often offset the gain from the sale of the property. Yay! Next, if you have more losses than gain (which happens more than you think), the excess losses spill over and can offset your W-2 wages, business income, or investment income.

Form 8582, which accompanies your individual tax return (Form 1040), tracks unallowed passive activity losses for each activity. If you have three rental properties which have losses, and assuming they are all long-term rentals and you don’t qualify with real estate professional status (REPS), each property would be listed on Form 8582 as a separate activity (ok tax nerds, Yes, taxpayers may elect to group activities under Regulations Section 1.469-4 and the close cousin 1.469-9(g) for REPS).

Sidebar: Passive losses from certain K-1’s are also tracked using Form 8582 so that when you either have passive income or you dispose of the K-1 (redeem, sell, get out of the investment, etc.), these previously unallowed losses are accounted for.

The IRS in their topic above uses the word disallowed. Form 8582 uses the word unallowed. Schedule E Part II uses the word unallowed. These can be viewed as the same, but unallowed is preferred unless you are playing scrabble then disallowed is fair game. According to Cornell Law, “Disallowance means a denial. In the context of taxes, disallowance is a finding by the IRS after an audit that a business or individual taxpayer was not entitled to a deduction or other tax benefit claimed on a tax return.”

We digress. Other tidbits-

• The “release” of unallowed losses upon the sale of your rental property can certainly assist in your depreciation recapture and subsequent tax bill problem.
• When changing tax professionals, please ensure Form 8582 is discussed. If you break the chain between tax years, you might be hosed.

Who wants more? Of course you do! If you elected to group multiple rental properties as a single activity under the passive activity rules, selling one property might not release suspended losses. Grouping is commonly done to help satisfy material participation tests, especially when time spent across several properties is combined. However, the IRS then treats the group as one activity, meaning losses are generally released only when you dispose of your entire interest in the grouped activity. In some cases, a material change in facts and circumstances may allow regrouping, but that is not something to rely on casually.

Net Investment Income Tax

When you sell an investment property, net investment income tax (NIIT) is 3.8% of your property sale gains, and is triggered when your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for married filing jointly. For most people, MAGI for NIIT purposes is the same as adjusted gross income (yes there are exceptions, but roll with this one for now).

An annoying aspect for real estate investors is that the capital gain from the sale itself counts towards your MAGI. Your W-2 might be safe at $150,000 but if you sell a rental for a $300,000 gain, your MAGI is now $450,000. Because NIIT applies to the lesser of your net investment income or the amount your MAGI exceeds the threshold, you would pay the 3.8% tax on $200,000 in this example.

Sidebar: As mentioned in this section, your gains are loosely computed as selling price less purchase price, less improvements, less selling expenses plus depreciation recapture. Your mortgage balance has nothing to do with it; the cash you walk away with could be much lower than your gains based on a bunch of cash-out refinances and whatnot.

Back to NIIT. Once triggered given your MAGI thresholds, the 3.8% is applied to the lesser of the net investment income or the amount of investment income that exceeds the MAGI thresholds. The math can be a bit nutty.

Moving on… as we’ve described in other sections, rental properties are passive activities, and as such the sale of your rental property is considered investment income. It is no different than selling Tesla stock or receiving Disney dividends. The only three ways to avoid NIIT on selling your rental property are… dramatic pause… the only three ways are-

• being a real estate professional (REPS) as defined by the IRS,
• having the rental qualify for the short-term rental loophole in the same tax year as sale, or
• providing hotel-like services, or what the IRS Publication 527 Residential Rental Property calls substantial services. See our Schedule C versus Schedule E section for more information.

What do these examples have in common? The activity must be treated as an active trade or business rather than passive investment income.

Oh, the fourth way is to not have a gain upon sale. Shoot, and the fifth way is not have triggered net investment income tax MAGI thresholds in the first place. Keep in mind that suspended losses released from Form 8582 reduce your overall income and can help lower the MAGI used in the NIIT calculation.

Here is a summary table for review-

Rental Type	Material Participation	NIIT
Short-Term Rental Loophole	Yes	No
Short-Term Rental	No	Yes
Long-Term Rental	Yes	Yes (bummer)
Long-Term Rental	No	Yes
Any Rental With Real Estate Professional Status	Yes	No
Any Rental With Substantial Services*	No	Yes
Any Rental With Substantial Services*	Yes	No

The third row is a huge consideration- even if you materially participate, your gains will be subject to NIIT upon sale. As such, you need to materially participate in your short-term rental with an average guest stay of 7 days or less, or qualify as a real estate professional as defined by the IRS, or provide substantial services (note that all three must have material participation). Just slapping down a time log with 500 hours on your otherwise garden-variety long-term rental will not avoid NIIT applied to your gains upon sale.

The asterisk is a bit of a misnomer. Once you provide substantial services, the activity is no longer considered a rental activity under the passive activity rules. However, it can still be considered passive unless you materially participate. Yeah, this is an oddity but an important distinction.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Part 2 of our miniseries moves from the past (Cost Basis) to the present negotiation table. Ok, no one negotiates at a table these days- when’s the last time you met the buyer? We digress…

Purchase price allocation is where you can make some headway on your tax exposure. When you sell a rental property, the contract might state a single sales price of $1,000,000. However, in the eyes of tax code, you are not selling one asset. Generally, you are selling three distinct types of property bundled together. Huh? (yes this is a bit simplified, but stay with us)

We like to think of these as three different “Tax Buckets.” Every dollar of your sales price must be poured into all or most of these buckets, and the tax rates for each vary wildly. Does it sound better if every ounce of your rental keg must be poured into different glasses? The yard. The boot. The proper 8 ounce glam glass.

Your goal as a seller is simple: Fill the cheapest buckets first. Shocker, right?

• Land first. Why? No depreciation recapture. Land is usually what goes up in value (location location location).
• Building and land improvements second. Why? Depreciation is recaptured, Yes, but limited to your marginal tax bracket or 25% whichever is lower.
• Personal Property last, like dead last. Why? Depreciation is recaptured but is not limited like buildings and land improvements above. The good news is that furniture has terrible resale value. The bad news is that personal property identified with a cost segregation study usually goes hand in hand with the building and therefore has higher residual fair market value.

Let’s talk about each of these in turn. But first, a small word of caution- when we say fill these buckets in order, truly it is still based on fair market value of each bucket. It cannot be arbitrary.

And! We’ll throw a wrench in the order above near the end of this section, but you have to suffer through a few pages first. It’ll be worth it.

Land (Bucket 1, with Arbitrage)

When you sell a rental property, intrinsic to the deal is the conveyance of the land and the building. Yes, they are combined usually, but from a tax return perspective, these are different assets.

How does this affect you? You buy a $500,000 rental property which had land at $100,000 or 20% according to the county assessor. When you later sell for $900,000, the land might simply be $180,000 if the 20% ratio hasn’t changed. As such, more of the purchase price is being allocated to an asset that does not have recapture. That alone is not sexy since it is unlikely to help you with the other buckets.

But what if it could? What if land allocation could help?

What if the land increases more than the overall gain in property value? In other words, the market is rewarding geographic location more than the building itself (and the area could be heading towards the preference to buy, scrape and build new).

In many areas such as waterfront properties or trendy urban centers, the value of the dirt appreciates faster than the structure. If you are selling a property in an area where buyers are scraping homes to build new ones, the market is signaling that the value is almost entirely in the land.

Use this to your advantage. How? Consider-

Original Purchase Price (cost basis)	500,000
Depreciation Taken	75,000
Adjusted Cost Basis (a)	425,000
Sale Price (b)	675,000
Preliminary Gain (b – a)	250,000
Depreciation Recapture	75,000
Remaining Gain to Be Considered (c)	175,000
Years of Non-Qualified Use	3
Years of Total Ownership	12
Percentage (d)	25%
Non-Excludable Gain (c x d)	43,750
Excluded Gain under IRC Section 121	131,250

This table shows a reduction in depreciation recapture. How? The value of the property, as a whole, increased from $500,000 to $650,000. However, according to records or documents at the time of sale, the land increased from $100,000 to $300,000. Where did this $100,000 come from? Either the county assessment of the property (preferred) or an original appraisal (let’s assume it is correct or fair for sake of argument).

As such, when applying the purchase price to land first and building second, the amount applied to the building is $50,000 less than the unadjusted cost basis originally allocated to the building. In turn, the amount of depreciation recapture is reduced from $75,000 to $25,000.

Said in another way- by allocating more of the sales price to the land, you effectively convert what would have been 25% tax (recapture) into 20% tax (capital gains). On a million-dollar sale, this 5% spread can be significant.

Real estate scenarios where the land value increases year over year as a ratio to the overall value of the property are very common- as mentioned earlier, take any lakefront property in a nice area and do some historical review of the county assessment including new building permits for scrapes (tear down and rebuild). It will be enlightening.

Finally, this is an often-overlooked tax planning opportunity even among experienced tax practitioners because many real estate sales simply reuse the original depreciation allocation instead of revisiting the assets’ fair market value.

Fill that land bucket!

Building and Land Improvements (Bucket 2)

This is really two buckets in one with the same tax consequence but has a nuanced twist. Let’s break it down. We can all agree that-

• The Structure (39 or 27.5 years) is walls, roof, foundation, etc. Stable and perhaps increasing values.
• Land Improvements (15 years) are fences, driveways, landscaping, and parking lots. Mostly declining values.

Both asset classes are considered IRC Section 1250 property. So, why do you care?

Depreciation on buildings isn’t recaptured at ordinary income rates. Instead, it becomes unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25%.

Land improvements consist of items exposed to the elements which affects the life and functionality of the item. Think about a 15-year-old asphalt driveway. It is full of cracks, faded, and essentially needs to be ripped up and replaced (but let your buyer do that work!). A 15-year-old wooden fence is leaning and splintered. A lot of land improvements physically degrade to a low true economic value.

The building structure, by contrast, is the shell and contains the foundation, framing, steel and masonry. It is maintained, and it holds (or increases due to substitute materials cost) its market value over time.

When you allocate the purchase price, you want your numbers to be defensible in an audit. Arguing that a 15-year-old fence is worth $500 is incredibly easy to defend. Heck, maybe even $0.

Having said that, here is the real reason we push value to the structure versus land improvements, and it has to do with excess depreciation. Shhh, don’t let anyone else know the secret!

While both the structure and the land improvements are IRC Section 1250 property, they are depreciated differently. Therefore, they are recaptured differently when you sell. Huh?

Under IRS Section 1250 rules, any depreciation you take that is in excess of what straight-line depreciation would have been is considered “Additional Depreciation.” Because commercial and residential structures are required by the tax code (with some exceptions like gas stations) to use straight-line depreciation, they avoid this trap. Land improvements, however, often utilize bonus depreciation or Section 179 expensing. This excess amount is taxed at your ordinary income tax rate up to 37%. Yuck!

Who wants some code? IRC Section 1250(b)(1) reads-

(1) In general
The term “additional depreciation” means, in the case of any property, the depreciation adjustments in respect of such property; except that, in the case of property held more than one year, it means such adjustments only to the extent that they exceed the amount of the depreciation adjustments which would have resulted if such adjustments had been determined for each taxable year under the straight line method of adjustment.

And then, IRC Section 1250(a)(1)(A) comes in with this nonsense-

(A) In general
If section 1250 property is disposed of after December 31, 1975, then the applicable percentage of the lower of—
(i) that portion of the additional depreciation (as defined in subsection (b)(1) or (4)) attributable to periods after December 31, 1975, in respect of the property, or
(ii) the excess of the amount realized (in the case of a sale, exchange, or involuntary conversion), or the fair market value of such property (in the case of any other disposition), over the adjusted basis of such property,
shall be treated as gain which is ordinary income. Such gain shall be recognized notwithstanding any other provision of this subtitle.

See those words “ordinary income” at the end there? Did you pick up on the 1975 part?

Therefore, if you took bonus depreciation or Section 179 expensing on a driveway, and you allocate $50,000 of your sales price to that driveway, you will likely pay 37% ordinary income tax on a large chunk of that $50,000 (the amount that was “additional” beyond straight-line).

If you allocate that same $50,000 to the building structure instead (arguing the driveway has rotted in the sun and elements to a nominal value), that gain is safely capped at 25%. Yay!

In other words, by allocating value to the thing that actually holds value (the building structure) and assigning $0 to the things that rot (the land improvements), you successfully shift your sales profit out of the 37% tax bracket and into the 25% tax bracket.

But wait! You need to be reasonable. $0 driveways just don’t make a lot of sense. You cannot arbitrarily assign a value. Rather, it must be a fair market value determination.

Purchase price allocations, or PPAs for short, are manipulated often to improve tax consequences in deals and they can be scrutinized for abuse. As such, being thoughtful and methodical along with a dose of reasonableness can go a long way.

More on PPA and reasonableness as we shift to personal property.

Personal Property (Bucket 3, The Section 1245 Trap)

This one requires a fresh cocktail, or something so please take a moment. An IPA for your PPA. Ok, here we go-

Please recall our discussions on IRC Section 1245 and 1250 property. Quickly, Section 1245 is personal property (often identified with a cost segregation study or purchased as furnishings) and Section 1250 property is the remaining building. Why is this important?

Depreciation recapture on the building is capped at a 25% tax rate. If you are in the 37% marginal tax bracket, you enjoy a nice spread. Tax arbitrage.

Section 1245 property does not enjoy this 25% limit. First, bummer. Second, this can be a large surprise. Imagine $50,000 in Section 1245 recapture at a 37% marginal tax rate. This would be an $18,500 tax bill. You generally want to allocate as little of the purchase price as possible to this bucket to avoid being crushed by ordinary income tax rates. Yup, 5th grade math tells you that.

However, not all Section 1245 property is created equal. To legally and reasonably minimize this bucket, you must distinguish between two sub-buckets: We could call them Thing 1 and Thing 2, but we’ll use “loose” assets and “sticky” assets.

Loose Assets (Thrift Store Value)

These are items not physically attached to the property such as furniture, kitchen appliances, rugs, and window treatments. This issue is most prevalent with short-term or furnished mid-term rentals.

Some of this gets immediately tricky if you are not selling it furnished since now some of your loose assets will stay and some will go like a Clash song.

Regardless, how you originally handled these assets dictates your tax risk today.

If you purchased $40,000 in furnishings and immediately expensed most of it using the de minimis safe harbor provision (items costing $2,500 or less), you are generally in good shape. Because these items were expensed and typically not tracked on your fixed asset schedule, there is no depreciation to recapture when you sell. However, their tax basis is usually zero, so any portion of the sales price allocated to them could technically produce ordinary income. In practice, used furnishings rarely carry much value, so the amounts involved are usually small and often not worth losing sleep over.

Instead, let’s say you did report the $40,000 in furnishings as one big fat asset on a previous tax return (and we see this all the time). You now have a situation where there is a risk of depreciation recapture on the Section 1245 property which, as you know, does not enjoy the Section 1250 limit of 25%.

As the seller, you want this number to be low both from a tax perspective and a practical one since used furniture has little value. As the buyer, however, you want this number to be high so you can reset the life of the asset, and use bonus depreciation or Section 179 expensing as a nice tax deduction. The rub.

Sidebar: A lot of buyers do not want to pay for furnishings outside of closing via a separate bill of sale since it requires additional cash. Padding the overall sales price by $10,000 to account for the furniture only requires $2,000 in additional cash from the buyer (assuming a 20% down payment). This will likely not affect appraisals or loan-to-value calculations, and it is often easier for buyers to swallow, even if it complicates your tax allocation as a seller.

We’ll give you a rule of thumb in a bit. Next, let’s get sticky with it.

Sticky Assets (Functionality Value)

These are items typically identified in a cost segregation study such as specialty lighting, dryer hookups, dedicated electrical for appliances, and carpeting, and about a million other little things that are considered personal property.

Unlike a low-mileage couch, buyers do expect these things to be present in the property. They can be demanding that way, right? A house without dryer hookups or lights no longer functions as expected. Therefore, the buyer is assigning some value to them in their purchase offer. You cannot immediately argue that Section 1245 property from a cost seg is worthless, but you can argue the building components are rapidly depreciating (hence the 5- and 7- year asset lives).

So, how do you exit a cost segregation study? In other words, how do you minimize your recapture pain when you deducted that big cost seg depreciation?

If you bought a fancy pants short-term rental property and identified $200,000 of IRC Section 1245 property through an even fancier cost seg study, you likely depreciated that $200,000 rapidly with bonus depreciation or Section 179 expensing (you might have even opted out of 5-year bonus depreciation to spread the benefit while taking all of 7- and 15- year).

Regardless, and assuming 5 years later for the possible bonus opt-out, the IRS default expectation is to recapture that full $200,000 upon sale.

Recapture is calculated based on the fair market value (FMV) of the assets at the time of sale, not their original cost. While the IRS might argue the items are valuable because they make the building function, the counterargument is fair market value all over again. If the specialized wiring or carpeting were severed from the building, their value on the open market would be negligible.

Then again, buyers expect most if not all the IRC Section 1245 property to be present and functioning, so there is value.

The circular reference and eventual conundrum become- how much value?

If your sales contract is silent on allocation, which is common since no one thinks about this stuff until after the fact, here is a table to consider-

		Loose Furnishings			Sticky Cost Seg
Year		5-Year	7-Year		5-Year	7-Year
0-2		50%	50%		70%	80%
3-4		30%	30%		50%	60%
5-6		10%	20%		30%	40%
7-9		0%	10%		10%	20%
10+		0%	0%		10%	10%

What are we saying here? If your cost segregation study identified $60,000 in 5-year property, and that property from the service date (not the original date of build) is 5-6 years old, then we would allocate 30% of $60,000 or $18,000 of the purchase price to the 5-year property asset class.

Notice the floors in this approach. Loose furnishings eventually drop to a 0% floor because a 10-year-old mattress or appliance is practically worthless and holds no resale value. “Sticky” cost seg assets, however, hold a 10% floor; even if they are heavily aged, that specialized wiring or plumbing retains an inherent, functional connection to the building itself.

Where did this table come from? We developed it and refined it over time. It is heuristic guidance, not IRS standard. If you want an exact fair market value of your Section 1245 property, cost segregation companies can provide that too. This makes sense when the numbers get big such as large commercial properties with significant Section 1245 property.

Ordering Your Price Allocations

When fair market values allow flexibility, sellers typically prefer allocations in this order-

• Land, then
• Building Structure, then
• Land Improvements, then
• Sticky Cost Seg 1245, then
• Loose Furnishings 1245.

We prefer sticky ahead of loose simply because it is harder to justify a nominal or super low value for the cost segregation-identified Section 1245 property, so filling that last smells better if questioned. Also, you might find that with the right appraisal (i.e., detached third party without a dog in the fight) and a smart tax professional, there might be very little purchase price left to allocate to the Section 1245 bucket.

Recall that blurb before about throwing a wrench into the works? Here it is…

Another argument could be made to allocate to IRC Section 1245 property after land and before building structure and land improvements. Why? If you know the fair market value of the Section 1245 property, then allocate accordingly, leaving the residual gains pushed into the building structure and land improvements which have more favorable depreciation recapture rates.

At the end of it all, however, and we said before, purchase price allocations remain a fair market value analysis first. If at the end of your bucket-filling process you find your sticky cost seg and loose furnishings 1245value to be way too high, then the fair market value on other assets must be too low.

Purchase Price Allocation Challenges

As you sharpen your pencil, keep these basics in mind on PPAs and fair market values, and the reasonableness underscoring it all-

• Most residential and small rental property sales do not include a detailed purchase price allocation in the contract or closing documents. Instead, the agreement typically lists a single purchase price for the entire property.
• Because of this, the allocation between land, building, and personal property is usually determined later when the tax return is prepared. That is perfectly acceptable, but the numbers should still reflect reasonable fair market values.
• Where problems arise is when the buyer and seller report dramatically different allocations for the same transaction. For this reason, it is best to use defensible valuation methods such as appraisals, county assessor ratios, or other market data when determining how the purchase price should be allocated.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Part 1 of our miniseries first focuses on a cost basis audit, or what we jokingly call a trip down memory lane. Some would say revisionist history, but that seems extreme. We then turn our focus to depreciation recapture and / or Section 179 benefit recapture to warm up the IOU the IRS (and perhaps your state) extended to you over the years, and shockingly they are showing up at closing to call in the chit.

Cost Basis Audit

The first thing we recommend when selling any property, especially a rental property which might not enjoy a capital gains exclusion, is a cost basis audit. What do we mean here?

When WCG CPAs & Advisors gleefully accepts a new client, there is some level of trust in the prior tax professional’s work. For example, we obtain a fixed asset listing with associated depreciation schedules, and we see a rental property asset with a $400,000 building unadjusted cost basis and another $100,000 asset allocated to land. Cool.

But!

Were acquisition costs missed such as title fees and travel expenses associated with the purchase? Did the rental property owner install a new deck, but never told anyone? Is this $500,000 ($400,000 + $100,000) correct, or did something break within the gamut of prior year tax returns along the way?

No one cares until it comes time to sell and compute your gain. In other words, if $10,000 was missed on your cost basis, your depreciation might be artificially lowered by a few bucks, but who cares in the interim. However, this $5,000 at your long-term capital gains rate of 23.8% is suddenly more than a few bucks.

Therefore, we encourage a cost basis audit. This is a detailed review of the original purchase price, plus acquisition costs and improvements. This is a forensic review of your original purchase settlement statement and your history of improvements.

What are we looking for? Missed acquisition costs! Many tax preparers simply grab the “Contract Sales Price” from the first page of the closing statement or rely on county records, and move on. They often miss the capitalized costs buried on other pages. Did you pay for title insurance? Transfer taxes? Recording fees? Legal fees? These are all added to your basis.

What about forgotten improvements? Did you install a new deck in 2019? Did you replace the HVAC system in 2020? Real estate investors are notorious for paying cash for improvements or putting them on a personal credit card and forgetting to tell their accountant. If you spent $15,000 on a new roof three years ago but never added it to your depreciation schedule, that money is effectively gone.

There is a catch. You need to be extremely careful not to “double dip” on expenses.

As you might be aware, under the de minimis safe harbor rules, you may have elected to immediately expense items costing $2,500 or less (invoked annually). If you bought a $1,500 water heater in 2021 and deducted it as a repair expense, you received your tax benefit in 2021. You cannot also add that $1,500 to your cost basis now.

Don’t forget about the other safe harbors too such as small taxpayer safe harbor and routine maintenance safe harbor. These safe harbors can allow immediate expensing of items that are otherwise considered improvements, and therefore added to your cost basis.

Some of this is a challenge because you might know what your tax accountant did 7 years ago when you submitted a receipt for that HVAC replacement- then again, if it is not listed as an improvement on your fixed asset listing, at times we must then assume it was expensed.

Expensed or added to cost basis. Pick one. You cannot do both. Sorry, Charlie.

Depreciation Recapture

As we defined in our glossary- If you sell or otherwise dispose of depreciated business property including real estate property for a gain (the sale price exceeds the adjusted cost basis), depreciation recapture permits the IRS to take back (i.e., “recapture”) some of the tax benefits you received over the years through depreciation deductions. As such, depreciation might be a little tax bomb or IOU to the IRS.

When you sell, your gain is split into two buckets, and they are taxed differently. Capital gain is the appreciation of the rental property above its original purchase price. Recapture “gain” is the portion of the gain that is attributed to the depreciation you took.

Sidebar: Allowed versus allowable. There is nasty little tidbit in the tax code which states that cost basis must be reduced by depreciation allowed (what you actually took) or allowable (what you should have taken).As such, if you did not deduct depreciation in the past, we need to compute the missing depreciation, expense that with a Form 3115 and IRC Section 481(a) adjustment, and then “sell” the property.

The play on depreciation with assets which don’t normally depreciate, such as real estate, is to take the cash savings from reduced taxes and redeploy them into other investments. This is nearly identical to any pre-tax IRA or 401k contribution. The IRS will be asking for you to pay taxes in the future; until then, you enjoy more spendable cash “on loan” from the IRS.

Please recall our discussions on Section 1245 and 1250 property. Quickly, Section 1245 is personal property and is usually identified with a cost segregation study. Section 1250 property is the remaining building. Why is this important?

Here is where exact terminology matters. True depreciation recapture (such as the gain on Section 1245 personal property) is taxed as ordinary income. However, the standard straight-line depreciation taken on your physical rental building (Section 1250 property) is technically classified by the IRS as Unrecaptured Section 1250 Gain.

Unrecaptured Section 1250 gain is not ordinary income; it is a specific subset of long-term capital gain that is capped at a maximum tax rate of 25%. As such, if your marginal ordinary income tax bracket is 37%, this portion of your gain is protected by that 25% ceiling. This creates a fantastic tax arbitrage: you were able to deduct the depreciation over the years against your 37% ordinary income, but you only must “pay it back” at a maximum rate of 25% when you sell.

This leads us to purchase price allocations between all the various types of property and asset classes.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Now that you have survived the betterment and adaptation tests, you have arrived at the gray waters of restoration. Under the Tangible Property Regulations, you must capitalize an expenditure as a restoration if it replaces a “major component or substantial structural part” of your Unit of Property (UoP), as defined in Step 2 previously. Yeah, got it, now what?

Welcome to the jungle (aka, the Wiggle).

But how do you define “major” or “substantial”? Is it dollars? Is it physical size? The IRS refuses to give us a bright-line percentage, but they do give us a zillion examples. Let’s look at a famous one found in Treasury Regulations Section 1.263(a)-3(k)(7):

Example 25: Not replacement of major component or substantial structural part; windows. U owns a large office building… The building has 300 exterior windows that represent 25 percent of the total surface area of the building. In Year 1, U pays an amount to replace 100 of the exterior windows that had become damaged… Therefore, the replacement of the 100 windows does not constitute the replacement of a major component or substantial structural part of the building, and U is not required to treat the amount paid as a restoration…

Yawn. There are a total of 31 examples like this if you cannot get enough. But keep this specific 100-windows out of 300 total ratio in mind as we explore the maze.

The 33% Heuristic

When you are dealing with discrete, countable components within a system (like windows, doors, or individual condenser units), you can use physical math.

On one hand, the 100 out of 300 is a very specific percentage (33.3%). On the other hand, the IRS explicitly states that a hard bright-line rule does not exist. Regardless, practitioners use the 33% mark as a highly defensible barometer. Why? At the end of the day taxes become binary- yes or no? In other words, we must choose.

What if you need to replace an HVAC unit? In a single-family rental property, the HVAC system generally only has one component. Replacing it means replacing 100% of the system, which commonly triggers a restoration (capitalize). However, if you have an apartment building with 10 rooftop HVAC units all tied together as a system, and you replace 2 of them, you are only replacing 20% of the UoP. That falls well below the 33% barometer and can often be treated as a repair!

Sidebar: Using the window example, if you replaced all 300 windows at once, it would absolutely be a capital improvement. However, if you replace 100 each year for three years, you might be able to call it all routine maintenance/repairs. Spreading things out helps with cash flow and maximizes immediate deductions. This is a potential win-win, but don’t break out the bubbly quite yet. Substance? Form? Gaming the system? The IRS will look at the series of events holistically and could label it a wholesale improvement based on the overall facts and circumstances.

The Continuous System Dilemma

Counting windows and HVAC units is reasonably easy. But what happens when you are dealing with a continuous system like plumbing or electrical where the components aren’t easily countable? How many feet of wires does your rental have?

To have a reasonable tax position when you argue that what you did was not material or substantial, consider the following:

• Physical Segmentation (The Baseline): This is the most objective metric. If the building has 1,000 linear feet of plumbing supply lines and you replace 150 feet, you have a physical metric to point to (15%). Because 15% is well below our 33% heuristic, it leans heavily toward an expensed repair. Clearly this is a bit laughable since knowing the total amount of plumbing is silly, but it illustrates the math at any rate.
• Relative Cost and Value (The Fallback): Often, physical segmentation is impossible to calculate without ripping open the walls. In these cases, use value as a proxy. Compare the cost of the replaced portion against the estimated replacement cost of the entire system. If the total plumbing system would cost $50,000 to replace, a localized $5,000 repair falls well below the threshold of replacing a “substantial structural part.” Keep in mind that replacing an entire plumbing system is significantly more costly as a retrofitted renovation than as a new-build. This actually works to your advantage, as it inflates the replacement value (your denominator) and keeps your repair percentage lower.
• Qualitative Function (The IRS Suit Argument): This is where the rubber meets the road. Even if a replaced portion represents a tiny percentage of the total system’s physical footprint or value, capitalization might still be required if the component performs a discrete and critical function within the system (UoP).

On the qualitative function nonsense that is not taxpayer friendly, consider these bookends-

• Main Sewer Line: This is a critical choke point. If you replace the main sewer line connecting the rental property to the city system, it is usually a capital improvement (restoration), regardless of the cost relative to the whole system.
• Branch Lines: Conversely, if you replace the branch lines servicing the second-floor bathrooms, this is generally a repair. The system can still mostly function without those specific lines, meaning they do not hold the same critical functional weight as the main.

In practice, function often beats percentage.

If your expenditure survives the qualitative function test and falls below the 33% heuristic, congratulations: you have successfully navigated the gauntlet and you have a strong position to expense the repair!

No Bright Lines

When the IRS first proposed these rules, CPAs, tax attorneys, and industry groups flooded them with comment letters practically begging for a quantitative safe harbor on what constitutes the replacement of a “major component or substantial structural part.” Why not? As we just mentioned, we all like binary situations- Yes or No, and certainly not the Maybe So.

IRS declined.

Here is exactly how the IRS addressed it in the Final Tangible Property Regulations Preamble regarding Betterments and Restorations:

Several commenters requested that the final regulations provide a bright-line test for determining whether an amount results in a material increase in capacity, productivity, efficiency, strength, quality, or output… The IRS and the Treasury Department decline to adopt a bright-line rule for this purpose. Because of the inherently factual nature of the betterment inquiry and the varied nature of the property and situations… a single bright-line test would be inappropriate.

Regarding Restorations (specifically replacing a “major component”), they said the exact same thing:

The final regulations do not adopt a bright-line percentage… The IRS and the Treasury Department believe that a quantitative threshold for major components would be difficult to apply and would yield inappropriate results in many cases.

They ruled that determining a major component will forever remain a subjective “facts and circumstances” test based on qualitative function and relative size. To help taxpayers, if you can call it that, they pumped the regulations full of those 31 highly specific examples (like Example 25: the 100 out of 300 windows). More is not always better.

By Jason Watson, CPA
Posted Monday, March 30, 2026

If the expenditure meets the betterment, restoration, or adaptation tests, then it is generally considered a capital improvement, and therefore must be capitalized and depreciated (versus immediately deducted).

The final tangible property regulations define these terms in amazing detail, but here is a quick summary with the real estate investor in mind-

• Betterment. You fix a material defect in the rental property or UoP that existed prior to acquisition or arose during ownership, such as a cracked foundation. An addition or enlargement, such as finishing the basement, is also a betterment. A betterment also includes amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property (UoP).
• Restoration. You replace a major component such as replacing a roof. You restore a UoP that has deteriorated to a state of disrepair and is no longer in ordinarily efficient operating condition, including rebuilding after a casualty loss.
• Adaptation. According to the final tangible property regulations, “An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with your ordinary use of the unit of property at the time you originally placed it in service.” Is converting a garage into a casita or another bedroom considered an adaptation or betterment? Hmmm…

You can think of BRA or BAR when trying to remember these. No one thinks of ARB or RAB, however. Like never.

Let’s focus on betterments and adaptations since those are the “dead in the water” buckets.

Betterments

With reference to betterment and the word “material,” the IRS offers this-

The term “material” is not defined in the final tangibles regulations. Although the final tangibles regulations include examples that refer to percentage increases, these examples are provided to assist you in understanding the rules. These percentages are not intended to set a standard, for example, a particular percentage increase in square footage or capacity, for determining whether the amount paid is a “material” betterment. In determining whether a betterment is “material”, you should use common sense and reasonable judgment as applied to your own facts and circumstances.

This is exactly why defining your Unit of Property in Step 2 was so critical. You cannot measure if an upgrade is material until you know the size of the denominator.

Imagine you have a large commercial rental with a massive, multi-zone HVAC system. One of the old 3-ton rooftop condenser units dies. New environmental codes require you to replace it with a modern, high-efficiency 4-ton unit.

If you look at the component: It has more capacity (4 tons vs 3 tons) and is vastly more energy-efficient. It looks exactly like a betterment. But wait, there’s more.

If you look at the UoP: You establish that the UoP is the entire building’s HVAC system (which has a total capacity of 100 tons). Great. Does upgrading one 3-ton unit to a 4-ton unit materially increase the capacity or efficiency of the entire 100-ton system? No. It’s a drop in the bucket. It bypasses the betterment test and survives to fight another day as safely lands in the “maybe” expense column and not automatically on the depreciation schedule.

In practice, betterment is often the IRS’s first argument when restoration is unclear.

Adaptations

According to the final Tangible Property Regulations, an expenditure is considered an adaptation if it adapts a Unit of Property to a new or different use that is not consistent with how you ordinarily used the property when you originally placed it in service. Adaptation is less about how much you changed and more about how the use of the property changed.

Wonderful, now what? Is converting a garage into a casita or another bedroom considered an adaptation or betterment? Hmmm… (Spoiler: Either way, you are capitalizing it because you are both increasing the utility of the property and changing how that portion of the property is used).

Restorations

If your expense is not a betterment or an adaptation, you move into the restoration analysis, which has some wiggle room. Cue up the music, Axl.

By Jason Watson, CPA
Posted Monday, March 30, 2026

This one is a bit trickier, but it is a fantastic and wildly underutilized safe harbor for rental property owners. Now that you’ve defined your Unit of Property (UoP) in Step 2, you can test if your expenditure qualifies as routine maintenance.

According to the Tangible Property Regulations, you are not required to capitalize (and therefore may immediately expense) repairs that:

• Are recurring activities that keep the property in its ordinarily efficient operating condition, AND
• You reasonably expect to perform more than once within a 10-year period.

Note: For building structures and systems, that 10-year clock begins when the rental property is placed in service.

The Reasonably Expect Reality Check

The rule explicitly reads “reasonably expect.” What if you expect to perform routine maintenance every 7 years, but by some miracle or sheer luck, you don’t actually do so, and it lasts 12 years? Do you lose the deduction?

It becomes a bit more challenging, but as long as you can demonstrate that, at the time of the expenditure, you reasonably expected to perform the activity more than once within 10 years, you have a valid argument to expense it.

A Pitfall: The “Major Component” Exception

Here is where skipping Step 2 (defining your UoP) will get you into trouble. The Routine Maintenance Safe Harbor has a pit of misery or hidden trapdoor baked into the rules: it explicitly does not apply if the work replaces a “major component or substantial structural part” of the UoP, which pushes you back into the improvement rules. Great! Not. How do you measure that?

You are never assessing a component in isolation; you are always assessing it against the whole system.

Let’s look at a water heater that you reasonably expect to replace every 7 years. Because 7 years is less than 10, it feels like an automatic win. But watch how the size of the UoP changes the outcome:

• Scenario A: Let’s say the water heater represents 20% of the entire plumbing UoP. You replace it every 7 years. So far so good. At 20%, it is likely not a major component of the overall plumbing system.
• Scenario B: The plumbing system is so small that the water heater represents 50% of the total plumbing UoP. You replace it every 7 years. Yet again, so far so good. However, at 50% of the system, it is very likely to be viewed as a major component.

Both the frequency and the nature of the activity matter. Replacing small, repeating components fits this safe harbor much more naturally than replacing central or critical components, even if both occur on a similar timeline.

Granted, this example illustrates the bookends in an unnecessarily dramatic way. But what is not dramatic is that it underscores the challenge. If you are arguing the major component or materiality tax position, then you are in a facts and circumstances argument. Don’t take this as being a bad thing- it’s just a thing. While we all like bright lines and safe harbors, they don’t always afford the “yeah, but my facts are unique” argument.

By Jason Watson, CPA
Posted Monday, March 30, 2026

If your expenditure was too big to slide into the de minimis or small taxpayer safe harbors from Step 1, welcome to the jungle- we’ve got fun and games, as Axl would say.

Before you can apply any math or functional tests to figure out if you repaired or improved something, you must define the playground. What exactly are you fixing? In tax terms, this is called determining your Unit of Property (UoP).

Historically, the UoP was generally considered the entire building, including all its structural components. However, under the final Tangible Property Regulations, specifically 1.263(a)-3(e), the IRS explicitly requires you to carve out the building’s major internal systems from the building and its structural components.

This is actually a good thing.

The improvement versus repair analysis must be applied independently to the building structure and each of the following 8 key building systems:

• plumbing system
• electrical system
• HVAC system
• elevator system
• escalator system
• fire protection and alarm system
• gas distribution system, and
• the security system.

So, you have 9 total Units of Property if you count the building structure itself.

Why Does This Matter? Defining the UoP is arguably the most critical step in defending a repair deduction. Why? Because the UoP becomes the denominator for every test that follows.

You do not measure the scope of a plumbing repair against the value of the whole building. You measure the scope of a plumbing repair against the total plumbing system. Replacing 20% of a building sounds small. Replacing 20% of a plumbing system starts to feel very different.

If you skip this step and use the wrong denominator, you will either incorrectly capitalize a valid repair, or you will take an aggressive deduction that perhaps some suits at the IRS would disagree with.

Sidebar: Ironically, the same real estate investor who will happily pay thousands of dollars for a cost segregation study to aggressively carve up a property into discrete components for accelerated depreciation often completely abandon that disciplined, system-level thinking when analyzing a $15,000 plumbing invoice. The UoP rules require the exact same level of granular, system-level thinking in both contexts.

We mentioned the word denominator, and that suggests a mathematical equation or formula. The problem is how you measure that denominator—by dollars? by physical scope? We dig into these head scratchers in a bit.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Are your individual invoices small enough ($2,500 or less) to expense under the de minimis safe harbor? Are your total annual maintenance and repairs (which includes cleaning, by the way) under the strict $10,000 / 2% limit to deduct under the small taxpayer safe harbor?

The second one is frankly one that is often missed, but even the first one is missed quite a bit. We see lawnmowers and window air conditioners listed on depreciation schedules. Who knows? Maybe some tax professionals sell the valuation proposition by complicating the uncomplicated. Oh well.

Enough of the soap box- if you can slide your expenditure into one of these two safe harbors, you get to skip the rest of the madness and immediately reduce your rental income for the year. Yay!

De Minimis Safe Harbor Election

We’ll start with the easiest one. As outlined in IRS Notice 2015-82, the IRS increased the de minimis safe harbor threshold from $500 to $2,500 per invoice or item for taxpayers in 2015. What does this mean? Anything you purchase including repairs and maintenance that are $2,500 or less per invoice or per item as substantiated on the invoice may be expensed and therefore deducted immediately (versus capitalizing as a fixed asset and depreciating).

You buy four dishwashers for your 4-unit rental property. The total invoice is $4,000, however, each dishwasher is $1,000. As such, since $1,000 is under $2,500 (even in Canada that math is correct), you can use the de minimis safe harbor.

The de minimis safe harbor doesn’t change your ability to deduct repair and maintenance costs that don’t qualify under the de minimis safe harbor. Is that double-talk? Maybe. How about this- you can use other safe harbors should you be unable to qualify under de minimis. Some more yay!

Some fine print- If the de minimis safe harbor is elected under Treasury Regulations Section 1.263(a)-1(f), it must be applied to all materials and supplies, and more broadly to amounts paid to acquire or produce tangible property, that meet the de minimis requirements, except for those the taxpayer elects to capitalize and depreciate. This sounds ominous but is quite minor.

Safe Harbor Election for Small Taxpayers

For the little investor in the real estate investment world, we have a practical safe harbor for expenditures that would otherwise be deemed improvements requiring them to be listed as a fixed asset and depreciated. Yuck.

Sidebar: Don’t blame us. The safe harbor is truly called small taxpayer. Ok, perhaps we piled on with the little investor comment. Just having a little tax and accounting fun. It should be called small asset safe harbor.

Two criteria-

• You have less than $10 million in gross rental income across all activities.
• The building’s unadjusted cost basis is $1 million or less. This excludes land, land improvements (driveways, fencing, etc.), and personal property (IRC Section 1245 property) identified through a cost segregation study.

If you meet these, then if the total amount paid during the taxable year for repairs, maintenance, cleaning, improvements, or similar activities performed on such building property stay under $10,000 or 2% of the unadjusted cost basis, whichever is more restrictive, you can expense all of it immediately as repairs and maintenance.

Sidebar: Maintenance is beyond screwdrivers and drywall. Turn-cleaning is a standard maintenance expense that keeps your rental property in normal operating condition. Time and therefore expense related to washing linens or mopping floors is viewed the same as swapping out a door lock.

Read that again. It is the total amount for the tax year, not per item or per occurrence.

Quick example- you buy a rental for $600,000 and the building is $400,000 of the overall purchase price. You spend $5,000 replacing the HVAC (a misnomer since HVAC is a system, and you probably replaced the air handler of the system, but we digress) and have an additional $1,000 in routine repairs. Let’s calculate your small taxpayer safe harbor ceiling:

• Your 2% limit is $8,000 (2% of $400,000).
• The absolute cap is $10,000.
• You are bound by whichever is more restrictive. In this case, your limit is $8,000.

Keep in mind that this is all repairs and maintenance combined. If you spent $5,000 on the HVAC unit, plus another $7,000 on other repairs and maintenance, then you exceed the limit. Blow past the limit by a dollar, and you are back in the full repairs versus improvements analysis. No partial credit. In other words, you cannot take $10,000 and expense it, and capitalize the remaining $2,000.

What if a part of your HOA dues includes maintenance of the landscaping? Things that make you go hmmmmm.

Tax Return Mechanics

Both safe harbors require an annual election with your tax return; they do not apply automatically. Yawn.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Generally, there are two ways to compress time and hurry the tax benefits when you purchase and deploy certain property- bonus depreciation and Section 179 deduction (what some people call instant expensing). To be certain, Section 179 can be viewed as a form of “accelerated depreciation” since a) you list the property on your fixed asset listing of your tax returns, and b) there is depreciation recapture should the business use fall to or below 50% or you sell property (either the property itself or the associated rental property).

Sidebar: Technically, IRC Section 179 is an expensing tool, but many in the accounting industry lump it with accelerated depreciation discussions. Also, the 50% rule is another tribal standard. The true language of IRC Section 179(d)(1) is “The Secretary shall, by regulations, provide for recapturing the benefit under any deduction allowable under subsection (a) with respect to any property which is not used predominantly in a trade or business at any time.”

Section 179 lost a lot of its sexiness in 2018 once bonus depreciation hit 100% for five years, and even 80% in 2023. For 2024, bonus depreciation is 60% and as such Section 179 was back as a great rental property tax deduction and tax savings tool when appropriately leveraged. Timberlake might be bringing sexy back, but Section 179 is in the mix. Did we take that too far? Whatever. Keep reading about bonus depreciation for 2025 through 2030 with the One Big Beautiful Bill Act.

Sidebar: Several states decouple from the federal tax code, and do not allow bonus depreciation. As such, regardless of how sexy bonus depreciation might be (see what we did there), Section 179 expensing might be better given your state.

If you are reading this without an understanding of Section 1245 property and how it differs from Section 1250, please check out our section on Cost Segregation. When it comes to rental properties and certain real estate investments, identifying Section 1245 property allows for a portion of the property (asset) to be instantly depreciated, or “bonused” as some say, or deducted with Section 179. Yes, there are some exceptions when referencing Qualified Improvement Property for nonresidential property which we discuss in a bit.

Let’s run through this from a residential rental property perspective first. Then we’ll tackle the nonresidential issues with Section 179 and qualified improvement property, and how short-term rentals and transient tenants flip the narrative.

Accelerated Depreciation with Bonus

To reiterate, certain property purchases allow for a portion of the property (asset) to be instantly depreciated, or “bonused.” What do we mean by a portion? 2022 was the last year of 100% bonus depreciation. 2023 was 80% and 2024 is 60%. However, thanks to the One Big Beautiful Bill (OBBB, OBBBA, or OB3 as some like to say), bonus depreciation is back to 100% for 2025 through 2030. 2023 and 2024 tax years are still hosed unfortunately.

To be eligible for bonus, the property’s useful life cannot exceed 20 years.

If you are reporting bonus depreciation on a pass-through entity (PTE) tax return, it will generally be mixed in with all depreciation, and listed as a deduction among other deductions. This contrasts to Section 179 which is listed as a separate item on the PTE’s K-1 issued to the members or shareholders. Why? Section 179 has personal limitations that are managed on Form 4562 of your individual tax returns (there are some other nuances with basis, but we’ll avoid that topic for now).

Bonus depreciation does not have a limit. However, as we’ve discussed in various places including our state problems with your rental property section, many states decouple from federal tax code and do not allow for bonus depreciation.

Electing Out of Bonus Depreciation

Additional first-year depreciation, or what is commonly referred to as bonus depreciation, is required unless you opt out. Why would you want to opt out? There are a handful of tiny reasons, but the biggest is planned future increase in taxable income and therefore higher tax rates. In other words, would you rather take a depreciation deduction at a low tax rate or a high tax rate?

There are also tax planning considerations when rental property losses might be limited this year, but fully deductible in future years (think real estate professional status or short-term rental loophole). This can be a bit of crystal ball type stuff and must be handled carefully.

Electing out of bonus can be done annually and is specific to an asset class such as 5-year, 7-year and 15-year. It is also specific to assets placed in service in that year. Therefore, you can elect out of 7-year bonus depreciation in 2025 because it made sense from a tax planning perspective, and then purchase another rental property and perform a cost segregation study in 2026 to take full advantage of all asset classes including 7-year assets for bonus depreciation.

Electing out can also be a problem. Let’s say you opted out in 2023 for whatever reason, and you want to do a cost segregation study paired with a Form 3115 Change in Accounting Method for a rental you placed in service in 2023. You do this in 2026 because a) you have high income and b) your rental property qualifies for the short-term rental loophole. So, 2026 is a nice time for a big deduction.

However, bonus depreciation is unavailable to you- rather, you would still do the cost seg but you would generally need to amend 2023’s tax returns and utilize Section 179 expensing. Then again, that option might not be attractive if 2023’s passive losses are being limited or if Section 179 is not providing the benefit that bonus depreciation would have.

There are rules to “opt back into” bonus depreciation by amending your originally filed tax return within 6 months or asking the IRS for permission through a Form 3115 Change in Accounting Method.

Section 179 Deduction

Generally, IRC Section 179 allows businesses to deduct the full purchase price of qualifying equipment and property bought or financed during the tax year. Here is the exact verbiage of IRC Section 179(a)–

(a) Treatment as expenses.
A taxpayer may elect to treat the cost of any section 179 property as an expense which is not chargeable to capital account. Any cost so treated shall be allowed as a deduction for the taxable year in which the section 179 property is placed in service.

Sounds simple enough, right?

However, rental properties are not automatically considered a trade or business. The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts over time. The Supreme Court has interpreted “trade or business” for purposes of Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit. We would argue that rentals and general real estate investments fall under this auspice otherwise you wouldn’t do it. Sure, we all want that short-term tax loss to offset other income, but ultimately you want to make money.

For rental properties in particular, the presumption is that they are passive and on the opposite end of the business spectrum.

As stated just a second ago, a business must have a profit motive; whether you actually earn a profit is irrelevant; it is your motivation and subsequent actions that dictate this determination. This is a critical distinction since most rental properties have a loss, especially in the early years with current market rent combined with depreciation and / or with relatively high mortgage interest, or both. Moreover, if you could raise rent to turn a loss into a profit, you would, but silly things like Adam Smith and market economy get in the way.

In addition to your profit motive, your participation in the business must be regular and continuous. Do not confuse this with material participation which has a series of bright line tests for short-term rental loophole or real estate professional status when viewed in the context of rental properties and real estate investments.

Armed with this knowledge, does your rental property qualify as a business?

Typically, owning a rental property should generally qualify- profit motive, and regular and continuous participation. However, it is not a slam dunk. By using Alvary v. United States, 302 F.2d 790 (2d Cir. 1962) and Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953), the IRS and others have come up with a mini facts and circumstances checklist-

• the type of rented property (commercial versus residential property)

• the number of rental properties (volume)

• taxpayer reliance on the activity for lifestyle or income

• time and effort spent on daily operations

• the types and significance of any ancillary services provided within the activity (think short-term rental, hunting lodge, tours, etc.) the terms of the lease (for example, a short-term versus long-term lease), and

• conformity to Section 199A’s preamble

We will talk more about the Section 199A qualified business income deduction (QBID) in a bit, but here is a snippet from page 16 the final regulations which eerily look familiar to the list above-

In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

That doesn’t really stand out as helpful or definitive either. The good news is that both the courts and the IRS have consistently found in favor of rental property owners and have allowed broad support for the profit motive including the regular and continuous requirements. Yay! However, in Grier v. United States, 120 F.Supp. 395 (D.Conn. 1954) the taxpayer lost. How?

Edgar Grier inherited a house from his mother that she had rented out for many years to the same tenant. This same tenant continued to occupy the property until Grier sold it 14 years later. Over the years, little management work was required, but Grier did take care of such details as replacing the furnace. The IRS and court found that the house was an investment, not a business for Grier. The court noted that this was the only rental property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business.

This court case can be problematic, right? The court recognized that this was Grier’s only rental. So, do you need more than one? A whole gaggle? Perhaps. Or do you just need to involve yourself more in your single rental property activity, and document the heck out of it? Doesn’t hurt. Then again, things have changed a bit since 1954.

Profit motive. Got it. Continuous and regular. Wonderful. Now what? In the past, Section 179 could not be used to deduct personal property used in residential rental property. However, the Tax Cuts and Jobs Act (TCJA) eliminated this restriction starting in 2018. This means that rental property owners can now use Section 179 to deduct the cost of personal property items they purchase for use inside rental properties. For example, kitchen appliances, carpets, drapes, or blinds, just to name a handful. See our section on rental property renovations. Fun!

There is a subtle difference between the above examples, and nonresidential rental property. Under TCJA, Section 179 expensing has been expanded to include nonresidential roofs, heating, ventilation, air conditioning, and fire / alarm protection systems. Therefore, a new HVAC system for single-family residence typically cannot be expensed with Section 179 but might be allowed for an office building.

But wait! There’s more. Always more, right? You may use Section 179 expensing on an HVAC system in a single-family home that is considered nonresidential. Nonresidential home? How does that work? See our section on Qualified Improvement Property.

When To Bonus? When To Use Section 179? Both?

As mentioned earlier, if or when bonus depreciation is no longer 100%, Section 179 might be a better tax deduction. However, there are two issues- your rental activities must be a business. The Alvary and Gilford mini checklist is nice but the underpinnings of “trade or business” are good to review again so you can correctly couch your facts (and not end up like Grier).

The other issue is that Section 179 has limits. The maximum Section 179 expense deduction is $2,580,000 (for the 2026 tax year). This limit is reduced by the amount by which the cost of Section 179 property placed in service during the tax year exceeds $3,220,000.

Section 179 has trapped benefits within business entities such as partnerships and it also has a pesky recapture trigger should the rental property (or underlying asset) no longer be predominantly used in business (often 50% or below business use). We expand on these in a bit. Back to IRC Section 179 versus IRC Section 168 bonus depreciation.

What’s the hair on bonus depreciation? Not much, except that many states do not allow a tax deduction for bonus depreciation. In accounting geek speak, several states decouple from federal tax code.

Can you use both? Yes. You can dictate to the dollar how much Section 179 expense you want to use “first” and then piggyback it with bonus depreciation. Technically, Section 179 is deducted first with bonus depreciation being second. The net-net is good tax planning by a qualified real estate-minded tax professional.

Sidebar: See our Section 179 or bonus depreciation section in our Cost Segregation chapter for a deeper look into the 179 versus bonus conundrum. There are a lot of moving parts, and some of the decision requires either faith, patience or crystal ball, or all three. Best of luck.

By the way, bonus depreciation and Section 179 deduction is not available on foreign property.

Section 179 Problems With Partnerships

There is a wrinkle with IRC Section 179 when you hold a rental property inside a multi-member LLC (MMLLC) taxed as a partnership. Unlike depreciation, which can freely create a loss, Section 179 has built-in limitations that can restrict how much benefit you actually get.

The instructions for Form 4562 Depreciation and Amortization, reads-

Partnerships. Enter the smaller of line 5 or the partnership’s total items of income and expense, described in section 702(a), from any trade or business the partnership actively conducted (other than credits, tax-exempt income, the section 179 expense deduction, and guaranteed payments under section 707(c)).

What does this mean? The partnership must first determine its trade or business income, and that income effectively caps how much Section 179 can be allocated. Unlike bonus depreciation, which can push the entity into a loss, Section 179 has a second layer of friction-this time at the partner level.

While the partnership allocates Section 179 deductions through the K-1, each partner must apply their own limitations under IRC Section 179(b)(3), along with basis, at-risk, and passive activity rules. Unlike depreciation, which often flows through more cleanly, Section 179 deductions from a partnership can become effectively trapped depending on the partner’s individual tax situation and the character of the income they have available to absorb it.

Section 179 Problems With Moving Into Your Rental Property

Who wants more bad news? Let’s look at IRC Section 179(D)(10)-

(10) Recapture of deduction. If the property ceases to be used predominantly in a trade or business during any taxable year, the taxpayer shall include in gross income for the taxable year an amount equal to the excess of—

(A) the amount of the deduction allowed under subsection (a) with respect to such property, over

(B) the amount which would have been allowable under section 168 if no election under this section had been made.

Treasury Regulations Section 1.179-1(e)(1) reads the same way-

If the property is not used predominantly in a trade or business at any time before the end of its recovery period, the taxpayer must recapture the excess deduction as ordinary income.

What does this mean for you? If you take the rental property out of service because you are converting it back into a primary residence or second home or anything other than its income producing purpose, you will have to recognize a portion of the IRC Section 179 expensing as ordinary income. Technically, a portion of the benefit received is recaptured as ordinary income.

The exact phrase is “ceases to be used predominantly in a trade or business” which commonly means 50% or less according to IRS Publication 946 How To Depreciate Property–

If the use of the property drops to 50% or less in a year after you have taken a section 179 deduction, you must recapture part of the deduction. You do this by recomputing the depreciation from the year you placed the property in service, and including the difference in income in the year the business use dropped.

This verbiage in the IRS publication comes from Treasury Regulations Section 1.179-1(e)(2).

The portion part requires some calculations- the amount recognized as income is the difference between the amount expensed using IRC Section 179 and the amount allowed using typical depreciation.

Sidebar: The same thing happens on a business vehicle. You buy a big truck and use Section 179 to expense $32,000 (for the 2026 tax year). You start racking up personal use of the truck that exceeds 49.9% the following year. You will trigger recapture and recognize a big chunk of the $32,000 as income. Yuck!

However, and this a big however, that is Section 179. What about bonus depreciation? You might like this- under IRC Section 280F(b)(2), only listed property (passenger automobiles, entertainment / recreation, computers and peripheral equipment, and cell phones / telecommunication equipment) have a similar recapture rule to Section 179 when business use falls to or below 50%.

As such, if you use bonus depreciation coupled with a cost segregation study, and then you don’t have this recapture issue. However, and as a reminder, there are state issues since several states decouple from federal tax code and do not recognize bonus depreciation. Ah, decisions decisions.

As a tax planning consideration, if you have intentions to move into the rental property in the future, you might want to steer clear of IRC Section 179 in favor of bonus depreciation, or find a tax professional who doesn’t know about this rule. Kidding.

Can I Use Section 179 Against W-2 Income?

Yes. Who wants more Form 4562 instructions?

Individuals. Enter the smaller of line 5 or the total taxable income from any trade or business you actively conducted, computed without regard to any section 179 expense deduction, the deduction for one-half of self-employment taxes under section 164(f), or any net operating loss deduction. Also, include all wages, salaries, tips, and other compensation you earned as an employee (from Form 1040, line 1). Do not reduce this amount by unreimbursed employee business expenses. If you are married filing a joint return, combine the total taxable incomes for you and your spouse.

In Bloomberg v. Commissioner, 74 Tax Court 1368 (1980), the court used the term “in the business of being an employee” and this has been pointed to often when applying Section 179 expensing against W-2 wages. Here is a common example that you’ll see all over the world wide webs-

Example: You have a business income of $10,000 and qualifying Section 179 expenses of $90,000. Your spouse has a W-2 income of $50,000. Your husband-and-wife business income limit for Section 179 expensing is $60,000 ($10,000 plus $50,000).

If you elect to expense the entire $90,000, you deduct $60,000 this year and carry the $30,000 excess over to next year, where it again enters into a Section 179 computation. You may carry over the excesses to any number of years, without limit.

While miscellaneous deductions on Schedule A are no longer permitted on your individual tax returns after the Tax Cuts and Jobs Act, Form 2106 Employee Business Expense remains a valid tax form. As such, tax law continues to support the “in the business of being an employee” as referred by the Bloomberg court above.

Some States Do Not Recognize Accelerated Depreciation

California, for example, does not recognize bonus depreciation and has different limits for Section 179 expensing. According to California’s FTB Publication 1001–

The TCJA increased the amount of the additional first-year depreciation allowance from 50% to 100% for certain qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100% allowance is phased down by 20% per calendar year for property placed in service in taxable years beginning after 2022. The additional first-year depreciation deduction is allowed for new and used property. California does not conform to this provision.

It makes sense, right? The federal government can print money. States don’t have this luxury and must balance a budget (California notwithstanding). Don’t blame California necessarily- many states decouple from federal tax code and do not recognize bonus depreciation as a tax deduction. See our massive state problems with your rental property section for more painful information.

Accelerated Depreciation and Section 179 Recap

Some of this stuff can make you drool, and a simple net-net recap is all you need. Here we go-

• You can bonus depreciate 5-, 7- and 15-year property. This would be personal property that becomes Section 1245 property.

• You can Section 179 expense 5-, 7- and 15-year property connected with a residential property provided the activity is considered a business with regular and continuous participation with a profit motive.

• You can Section 179 expense certain items in nonresidential property that might otherwise not be eligible in a residential environment. Again, there is a cool nuance with nonresidential property that we review in our Qualified Improvement Property (QIP) section.

• You need to be mindful of Section 179 recapture should the rental property be taken out of service. This is where a portion of the previous benefit received is added back as ordinary income and taxed.

Here is a nice table (well, we think it is nice) to augment the summary-

Asset (the thing you want to deduct)	179	Bonus	Notes
5-Year and 7-Year Property	Yes	Yes	Standard 1245 property
Qualified Improvement Property (QIP, interior improvement)	Yes	Yes	Nonresidential only
Kitchen Reno, Bathroom Reno as QIP	Yes	Yes	Nonresidential only
Roof	Yes	No	Nonresidential, Sect 179 carve out
Furnace, Air Conditioner, Mini Split (HVAC)	Yes	No	Nonresidential, Sect 179 carve out
Appliances, Window Air Conditioner	Yes	Yes	Standard 1245 property
Water Heater (permanent)	No	No	Part of building, but have safe harbors
Water Heater (point of service, which is nice)	Yes	Yes	Standard 1245 property
Alarm, Security Systems	Yes	No	Nonresidential, Sect 179 carve out
Land Improvements (sidewalks, fences, landscaping, pools)	No	Yes	15-year 1250 property
Temporary Fencing, Playground Equipment, Nets / Hoops	Yes	Yes	Standard 1245 property
Hot Tub (free-standing on slab)	Yes	Yes	Standard 1245 property
Hot Tub (in ground or integrated with deck)	No	Yes	Land Improvement, 15-year 1250 property
Foreign Rental Property	No	No	Not eligible outside U.S.

Keep in mind that generally property with a useful life (recovery period) of 20 years or less is eligible for bonus depreciation. Also, the “Sect 179 carve out” above refers to IRC Section 179(e)(2). Oh, one more thing- nonresidential is a rental property with an average guest stay of 30 days or less (there are other provisions for mixed use commercial properties as well).

By Jason Watson, CPA
Posted Monday, March 30, 2026

Every time you pay a contractor or buy materials for your rental property, you face the exact same tax dilemma: Can I deduct this today, or do I have to depreciate it over decades? Yeah, sure, decades as in plural sounds dramatic, but it’s true- 27.5 or 39 years. Decades.

The answer lies in understanding the difference between a routine repair and a capital improvement. According to IRS Revenue Ruling 2000-4,

Section 263(a) and § 1.263(a)-1(a) provide that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property or estate. Section 1.263(a)-2(a) provides that capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.

Cool. The things you buy that have a useful life substantially greater than one year are considered a capital expenditure (capex) and must be capitalized in most situations. What the heck is capitalized? Is this a grammar thing?

There is capitalization in finance, and perhaps even in the deal structure on your rental property (debt versus cash versus investors). In accounting, and in tax return preparation, capitalization is an accounting method in which a cost is included in an asset’s value and expensed over the asset’s useful life, rather than expensed in the period the cost was incurred. Capitalization recognizes a cash outlay as an asset on the balance sheet rather than an expense on the income statement.

Yup, full on geek-speak.

Moreover, a capital improvement is an expenditure that increases a property’s value, useful life, or adapts it to a new use. The IRS often refers to these as betterments, restorations, and adaptations, or BRA for short. Fun!

Simply put, you can either expense or capitalize a purchase:

• Expensing the purchase is an immediate deduction and therefore an immediate reduction in rental income.
• Capitalizing the purchase requires listing the asset on your fixed asset schedule and slowly expensing it over time through depreciation.

Accelerated depreciation through bonus depreciation or Section 179, or both, can allow for an immediate deduction of an otherwise capital asset. We’ll talk about accelerated depreciation and Section 179 expensing in a bit.

Rental Property Repairs Safe Harbors

There are three safe harbors relevant to rental property owners and real estate investors. If your expenditure fits into one of these three categories, you can bypass the complex rules repairs versus improvements, expensed versus capitalized, and immediately deduct as an expense. Heck you might even get to collect $200 as you pass Go.

Here are the safe harbors. We will expand in nauseating detail later in the chapter:

• De Minimis Safe Harbor: The easiest one. If an item or invoice line-item costs $2,500 or less, you can generally expense it immediately.
• Small Taxpayer Safe Harbor: If your building’s unadjusted basis is $1 million or less, and your total annual maintenance and repairs (which includes cleaning, by the way) stay under $10,000 or 2% of the building’s basis, whichever is more restrictive, you can expense all of it.
• Routine Maintenance Safe Harbor: If you reasonably expect to perform this exact maintenance on a building system more than once every 10 years to keep it in normal operating condition, you can expense it.

Ok, neat. How do you use them? There is a 5-step process and just like the safe harbors, we will do a deep dive into each:

The 5-Step Repair Or Improvement Process

If your expenditure doesn’t neatly fit into a safe harbor, things get a bit more complicated. Here is the step-by-step roadmap to land at either expense or capital improvement:

• Step 1: De Minimis or Small Taxpayer Safe Harbor: First, you check the easy buttons like a stroll through Staples. Is your individual expenditure small enough to fit into the safe harbors that we just defined above?
• Step 2: Unit of Property (UoP) Analysis: Before you can test a repair, you must determine whether you are measuring the fix against the entire building structure or just one of its specific internal systems (like the plumbing or HVAC). Under the regulations, building systems like plumbing, HVAC, and electrical are treated as separate units of property from the building structure, which is why this step matters so much.
• Step 3: Routine Maintenance Safe Harbor: The 10-year rule. Next, test the repair against the system you defined in Step 2 to see if you expect to perform this maintenance more than once a decade. Water heaters is a wonderful example.
• Step 4: Betterment or Adaptation: The “dead in the water” tests. If your work materially increases capacity, strength, efficiency, or quality, it is called a betterment. Bad. Alternatively, if your work adapts the property to a totally new use, it is called an adaptation. Both are bad since they generally require you to capitalize. Also, the IRS loves to argue betterment when restoration is unclear, so even something that feels like a repair can get pulled into capitalization if there is any meaningful upgrade.
• Step 5: Restoration Guideline: The final gauntlet. If you made it this far, then functional tests are applied along with a “30%ish heuristic” to see if you merely repaired a system or completely replaced a major, critical component.

By Jason Watson, CPA
Posted Monday, March 30, 2026

If you want your retirement savings to grow tax free, you need a Roth IRA or Roth 401k. But don’t get too hung up on the phrase tax free growth. Roth IRAs and Roth 401k’s are not for everyone, and tax deferral today (non-Roth investments) might be the better answer as alluded to earlier (see Tax Savings and Tax Deferrals). Let’s back up the truck a bit and chat about the Roth tag on an IRA or 401k. Yes, a Roth IRA is different than a Roth 401k. The words have dramatically different meanings.

The 401k and traditional IRA came about because it was theorized that you had a much higher marginal tax rate during your wage-earning years than you would during retirement. For example, you could easily be in the 22% marginal bracket when you are 55, but be in the 12% bracket when you are 70. So, you would save taxes at 22% and pay them back at 12%. Not bad. This theory still holds true for hundreds of thousands of Americans but there have been some recent hiccups.

The data were shifting and suggested that the delta between wage earning marginal tax rate and retirement marginal tax rate was waning. So, some smart people got together and passed laws allowing the Roth IRA. Specifically, it was Senator William Roth from Delaware in 1997 who passed the legislation. Thankfully not much was going on in Delaware in the 90s and Senator Roth was able to create this excellent legislation. As you might be aware, the Roth IRA allows you to take after-tax dollars and invest it, and when you take the money out all of it is tax-free. Beauty!

So, the Roth IRA is not a tax deferral system like a traditional IRA. It is a pay tax now and avoid paying tax later system. But all that glitters is not gold as Robert Plant would say. A Roth IRA is only available to those who earn less than $252,000 per year for married filing joint taxpayers ($169,000 for single taxpayers) for the 2026 tax year, and a Roth IRA has very low contribution limits of $7,000 (for the 2026 tax year). Yuck. Now what?

Enter the Roth 401k which is a hybrid of a 401k and a Roth IRA, and can be a great selection among the small business retirement options. All the taste of a Roth IRA without the calories. Starting January 2006, many businesses amended their 401k plans and started introducing Roth options. So, even if your small business doesn’t adopt a 401k plan, your spouse’s job or your main job might benefit from the Roth 401k. Ask your benefits administrator to see if your other job or your spouse’s other job offers the Roth 401k option.

A Roth 401k has no income limitations and employees (you) can defer up to $24,000 (for the 2026 tax year) or $31,500 with catch-up. But business contributions cannot be designated as Roth. Since the business (employer) matching or profit-sharing is a deduction to the business, these funds are considered pre-tax and will not enjoy tax free growth. In other words, your contributions as an employee may be designated as after-tax or Roth type contributions, and the business’s contribution will be automatically designated as pre-tax or traditional type contributions.

Note: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

In essence, the Roth 401k has two accounts which can be managed separately within the 401k plan; one after-tax and another pre-tax.

Since the biggest challenge in deciding on using a Roth IRA or Roth 401k pivots on your marginal tax rate during retirement, and crystal balls don’t have the accuracy they used to, a good plan is to hedge against both. A Roth 401k has this feature built-in. Your deferrals as an employee can be Roth (post-tax) which hedge against retirement tax rates being similar to wage earning tax rates. Conversely, business funds are traditional (pre-tax) and hedge against retirement tax rates being lower than wage earning tax rates. Got it? How about this-

Employee deferral into 401k	Pre-Tax (deduction to you)
Employee deferral into Roth 401k	Post-Tax
Business contributions into 401k	Pre-Tax (deduction to you vis a vis the business)
Business contributions into Roth 401k	Allowed since SECURE Act of 2022

The mix between the two is the challenging part. 80% Roth and 20% pre-tax? 60-40%? Truly depends on your vision of retirement and your income sources. Bunch of rental income and residual earned income? Rich parents leaving you with thousands of dollars in dividend income? Gotta coin to flip? Two out of three? As mentioned earlier, financial planning and tax projections are the starting point for an answer that will unfortunately take a lifetime to validate. We can see your headstone now- “Her tax projections hit a 95% confidence interval. Kids are proud.” Small font or big stone. You decide.

Therefore, be careful of anyone telling you to always max out your Roth contributions without at least asking questions. Yes, there are zillions of calculators available on the internet- simply search for “ira versus roth ira calculator” and the inundation will be overwhelming. Or perhaps underwhelming.

Historically Roth options on a 401k plan used to be costly, but thanks to Adam Smith and his concept of economics, fierce competition has driven the pricing down. Many of WCG CPAs & Advisors small business owners leverage eTrade for their 401k plan.

By Jason Watson, CPA
Posted Monday, March 30, 2026

The i401k, solo 401k, solo k, uni k, or owners-only 401k (or whatever marketing name a bank or securities firm is selling) is a great small business retirement plan for-

• a one-person show,

• a one-person show with a spouse who also works for the business, or,

• a group of members in a multi-member LLC that does not have any employees. The Economic Growth and Tax Relief Reconciliation Act of 2001 modified the contribution limits and rules, and allowed for an emergence of the owners-only 401k plan.

Due to special tax rules, you can contribute more to this type of plan than other comparable retirement plans. The previous table in the beginning of this chapter illustrated this point with real life numbers. Under the usual rules for defined contribution plans such as SEP IRAs and profit-sharing plans, the deductible contribution is capped at-

• 25% of your salary or 20% of your earned income (as adjusted), or

• $71,000 for the 2026 tax year (plus $7,500 for catch-up) whichever is more restrictive.

But your deferrals as an employee into your solo 401k plan do not count towards the 20% and 25% caps, and this rule extends to your spouse. This is why the owner-only or solo 401k plan allows for the largest contribution because you have three sources of funding-

• You at $24,000 (for the 2026 tax year) plus $7,500 for catch-up (employee deferral), and

• Ditto for your spouse, and

• The business contribution up to 25% of your W-2 compensation or 20% of your self-employed earnings, and

• The funding is independent of each other (deferrals are deferrals, and contributions are contributions).

Read that again. Let’s say you have a $60,000 salary, $39,000 to invest into retirement savings and you are married. If only one person draws a salary, he or she can only defer a maximum of $24,000. But if a married couple pays a $30,000 salary to each person, then the total retirement deferral can be $48,000 without having to increase salaries to allow for a larger business contribution.

With a SEP IRA, in contrast, you would need a 4 x $48,000 or $192,000 salary to make the same retirement contribution (alternative math is $48,000 from the example above divided by 25%). The increase in payroll costs would wipe out your returns for at least two years. Not good. We’ll talk more about why a SEP IRA is used for crisis management and not for self-employed retirement plans (although the recent passage of the SECURE Act makes this moot, but we’ll explain anyway).

Here is an illustrative table showing this concept in a different way with salaries. This might not make the most sense in a rental property environment, but it gives you some things to consider-

	Option A		Option B
	Susan		Susan	Mark
Salary	110,000		70,000	40,000
401k Deferral	31,500		31,500	31,500
Business Contribution	27,500		17,500	10,000
Total 401k	59,000		90,600

Deferrals and contributions are discretionary, so you can cut back as cash flow and objectives change. The deadline for funding the business (employer) matching or non-elective contribution to your solo 401k plan is the tax filing deadline for your business including extensions. So, if you are an S Corp, the business tax return (Form 1120S) is due March 15. But with a tax return extension you could delay the funding until September 15. However, sole proprietors have until April 15 (the tax return filing deadline) or October 15 (if you file an extension) to make his or her deposits.

Employee deferrals for corporations (such as an S Corp) must be deposited by the 15th of the following month. So, a March 27 paycheck for Q1 would require you to deposit employee funds by April 15, which is typically a slow day around the WCG office (kidding, we’re celebrating at the local taco bar).

These deadlines are true for all 401k plans (solo, company-sponsored, Roth option, Safe Harbor provision, etc.). However, there is more wiggle room and less scrutiny for when employee deferrals are deposited since discovery is a challenge (in other words, you won’t rat on yourself). To keep things simple and elegant, we recommend following the same schedule as “big person” 401k plans.

As a side note, there is nothing saying you cannot wait until Q4 to make all your deferrals into your 401k plan, or any other quarter where perhaps a little bit of market timing or dollar cost averaging might be beneficial. Being the boss gives you flexibility with your small business retirement options.

Side Note: There is nothing saying you cannot wait until the last few months to make all your deferrals into your 401k plan, or any other quarter where perhaps a little bit of market timing or dollar cost averaging might be beneficial. Being the boss gives you flexibility with your small business retirement options.

Sidebar to the Side Note: Be careful about running out of room on your last few paychecks of the year. If you are paying yourself $60,000 a year or $5,000 a month, your November and December paychecks will be $10,000 and will not have enough room for a one and done $24,000 (for the 2026 tax year) employee 401k deferral. Then again, nothing that a bunch of payroll amendments can’t solve. Yeah, that sounds cheap and easy.

Unlike company-sponsored 401k plans, the individual or solo 401k plan does not need to perform discrimination testing of highly compensated employees (HCEs). More on that in a bit.

Solo 401k plans are also very economical to administer, allow for attractive retirement savings for you and your spouse, and remain simple enough to avoid all the hassles of a full company-sponsored plan. A company-sponsored plan (in contrast to a solo 401k plan) will cost about $1,000 to $1,500 per year (as of May 2026, WCG CPAs & Advisors has 90 team members and our 401k plan with Sure401k, a sister company to SurePayroll, was about $1,900 annually).

However, most solo 401k plans only charge for the commission or sales charge of the investments. For example, if you invest in A share mutual funds, there is a one-time sales load or commission of 5.75% (which might vary a bit between funds and fund classes). On that particular investment there are not any additional commissions, and the account fees are very small or non-existent. A shares (as opposed to C shares) are desirable for long-term investing since the commission paid is a one and done, and this cost is essentially amortized over several years.

The only downside is you cannot have a solo 401k or an owners-only 401k if you have employees. Even one part-time admin might blow this up depending on their hours and years of service (see below).

By Jason Watson, CPA
Posted Monday, March 30, 2026

Many taxpayers walk into our offices at WCG CPAs & Advisors and tell us they want to pay fewer taxes. Who doesn’t? We usually chuckle, and tell the client that he or she is the only one and it is sooooo refreshing to hear someone want to pay fewer taxes. Sorry for being snarky, but taxes are a way of life. Yes, our job is to have you pay the least amount of taxes permitted by law and not a dollar more, but that isn’t the only objective.

Tax savings comes in four variants- you can lie, cheat and steal, or you can understand the allowances, deductions and credits alongside the wiggle room afforded by the IRS code. We prefer the latter of course although the audit rate risk of 0.4% for S Corps and partnerships makes it all too tempting. Darn laws and ethics!

However, notice how 401k plans, IRAs, and other tax-deferred vehicles are not listed as one of the four ways to save taxes within self-employed retirement plans. A tax deferral is not automatically a tax-savings technique- it might be. It might not be. In true accountant fashion, it depends.

This is a real-life case- we have two Boeing engineers who saved about $1 million in the company 401k plan. The employee deferrals were all pre-tax, so they avoided about $250,000 in taxes since they were in the 25% marginal tax rate. Not bad.

However, they currently have four children, a house mortgage, and the usual tax deductions of a household of this size and age. When this couple retires in 2026, their marginal tax rate will increase to 32% due to their pension income and other income sources, and the dramatic reduction in tax deductions and credits

So, they saved at 25% and they will pay it back at 32%. Bummer. But wait! There is more to the story. Just like Paul Harvey, there is a page 2, or in the case of this book, on the next page. Yes, we are dating ourselves by referring to Paul Harvey but when that is all your parents listened to in the car, it is hard to forget.

What about all tax deferrals? Where does that money go? Usually to buy stuff like cars, vacations, food, and other consumables which don’t offer a return on investment. But what if this same couple invested the current tax deferrals into a conservative portfolio which yields a nice 5% rate of return (after tax consequence)? Things tilt in their favor- so we are back to having a tax benefit from tax deferrals. Huh?

The following is a ridiculously overly simplified table to demonstrate what we are talking about. Here are the assumptions-

• Defer $24,000 (for the 2026 tax year) per year for 10 years.

• Marginal tax rate is 22% during wage earning years.

• Rate of return on investing tax deferral savings is 5% net of taxes.

Year	Defer	Tax Savings @ 22%	Growth at 5%
1	24,000	5,280	5,544
2	24,000	5,280	11,365
3	24,000	5,280	17,477
4	24,000	5,280	23,895
5	24,000	5,280	30,634
6	24,000	5,280	37,709
7	24,000	5,280	45,136
8	24,000	5,280	52,933
9	24,000	5,280	61,120
10	24,000	5,280	69,716
Total	240,000	52,800	69,716

A quick recap- you deferred $240,000 and deferred $52,800 in taxes. That deferral grew to $69,716 because you invested it in a safe 5% investment portfolio. Great. What does this do?

Here is the realized savings for a 22% marginal tax rate during retirement-

Withdrawals Taxed at 22%	52,800
Growth on Tax Savings	69,716
Realized Savings (difference)	16,916

If your marginal tax rate remains the same at 22% you still see a savings of $16,916 as shown above. Again, this is predicated on you taking the tax you normally would have paid and investing it wisely. Not all of us are this disciplined.

But if your marginal tax rate increases from 22% to 35%, your savings is zero. Granted, to jump 13% in marginal tax rate between wage earning years and retirement years seems rare, but you get the point.

The moral of the story is this. Yes, tax deferrals can lead to tax savings, but you must work the system and be disciplined. Not just today, but for several years, and you need a jump in marginal tax rate that is 9% or less (in general). Assuming you have an increase at all. See below-

Withdrawals Taxed at 32%	76,800
Growth on Tax Savings	69,716
Realized Loss (difference)	-7,084

The bummer of this table is the leap from 22% to 32% marginal tax rate. Recall that you deferred tax at the 22% marginal tax rate. If you pay it back at 22%, then you are golden. You pay it back at 32% (the next marginal tax rate), then you lose money.

What should you do? Financial planning and review with your financial advisor is a must. Generally, we see people in the 10 and 12% marginal taxes doing post-tax (Roth). We see people in the 32, 35 and 37% marginal tax rates doing pre-tax. Then, we see people in the 22 and 24% marginal tax rates doing a mixture of post-tax and pre-tax retirement contributions.

We’ll talk about the built-in hedge with the employer (your business) contributions which must be pre-tax. In other words, your 401k deferrals are Roth (post-tax) and your employer contributions are pre-tax. This combination is a great hedge.

There is also the RMD angle. RMD is a common TLA (three letter acronym) tossed around at bingo parlors and country clubs, and stands for required minimum distributions. In a nutshell, the IRS forces you to take out a portion of your pre-tax retirement savings every year so they can collect on the IOU you gave them several years ago.

RMD calculations are simple. You take your age, find your life expectancy factor and divide that into your aggregate pre-tax account balance. Do you remember science class and discussing a molecule’s half-life? RMDs are very similar- over the course of retirement, you must withdraw pre-tax retirement dollars, but the calculus doesn’t force you to take it all out over your lifetime. It always has some factor of your age, and depending on your frugality you might die with a pile of money since the minimum leaves behind a lot.

The IRS released updated life expectancy tables and distribution periods in November 2020. The last time this was done was nearly 20 years ago! Here is snippet of the IRS RMD table which can be found in the appendix of IRS Publication 590-B (the most recent is for the 2022 tax year)-

Age	Factor
72	27.4
75	24.6
80	20.2
85	16.0
90	12.2

So, if you are 75 years old and had $1M in pre-tax money, your RMD would be $40,650 ($1,000,000 divided by 24.6).

What does this have to do with tax deferrals becoming tax savings? At some point you die, and if you only take out the minimum amount from your accounts, you will die with money in the bank. And this now-inherited IRA, for example, is taxed at your heirs’ rate. Under the new SECURE Act from December 2019, distributions from inherited IRAs to individuals other than spouses must be fully distributed in 10 years. There are some exceptions and other issues such as disabled individuals and minors, but that is the general gist.

The IRS wants to collect your previous IOU to them, like a Vegas bookie, and they don’t want to watch you keep kicking the can down the road.

So, for you there is tax savings built into the RMD system since not all the money is taken out and taxed. If you add in your heirs’ marginal tax rates, perhaps this changes from a “family unit” perspective. Heck, you’re the dead person- let your kids worry about your taxes by assuming them as their own. It takes a while to payback for all those sleepless nights and stinky diapers, but eventually it happens.

All kidding aside, here is something to consider- with life expectancy well into the 90s, your children might be retired too when you pass. Crazy but realistic, especially if you had kids before you had a career.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Most people have a pretty good handle on personal finance and basic retirement savings, and while the principles are generally the same in the small business world, a lot of business owners have a deer caught in your headlights at 2:00AM look when it comes to leveraging their business for retirement. And there is good reason- retirement planning within your small business carries a bunch more options and potential pitfalls (sounds like life in general, doesn’t it?).

Reasons for Small Business Financial Planning

There are three major wealth considerations for small business owners (or anyone for that matter)-

• Accumulation (fun and exciting part)

• Preservation (the tricky part)

• Transfer (the necessary evil part)

Each of these major wealth considerations are interwoven, needs comprehensive focus to ensure the necessary dots are connected, and should have no gaps or holes exist during transitions. That is where financial planning comes into play.

Accumulation is easy. Most people think if they toss some money at a mutual fund they are planning for retirement. Nope.

Preservation gets tricky since we need to have our money outlast our lives. And with people living well into their 90s, this can be tough. Let’s put it another way- if you work for 40 years, from age 25 to 65, you need to save enough to live for another 25-30 years. That is incredible. If you are spending $100,000 at age 55, you better be making $180,000 and putting the $80,000 into a moderate growth retirement vehicle.

Preservation also includes proper insurance, asset protection through trusts, pro-active maneuvering and other tools in the toolbox.

Transfer of wealth is automatic. We have yet to see a hearse with a trailer hitch. Or, said in a completely starker way, every life comes with a death sentence. How it is executed is partially up to you. Did we just ruin your appetite? Sorry.

Transfer of wealth can also be tricky. The current federal estate tax exemption is $12.92 million (for the 2023 tax year) per person, and a passed spouse can posthumously port his or her exemption to the surviving spouse. Not bad. And most people don’t have over $26 million in estate value. Rich people problems (now referred to as high net worth… the most over-used and water-downed phrase today).

Sidebar: According to a November 2019 Forbes article, over $30 trillion in wealth will be transferred by baby boomers. Furthermore, according to a 2018 study from Bankrate.com, millennials are less inclined to invest in the stock market. So, where this wealth goes is certainly unclear.

These federal exemption amounts are indexed each year, and while Congress can always vote to repeal, this estate tax exemption was written in stone with passing of the American Taxpayer Relief Act of 2012. However, various states have much lower exemptions. For the 2022 tax year, Connecticut was $9.1 million, Hawaii was $5.5 million, among other examples.

Nebraska does not have an estate tax, but they do have an inheritance tax (the recipient pays depending on relationship and could be as high as 13%). California, the class favorite, is one of 33 states that do not impose an inheritance tax. Apparently, you’ve been taxed to death and there is nothing left to tax when you die in California.

Therefore, just because you are out of woods federally, doesn’t mean the transfer your wealth is free of taxation. Get a plan.

What about your business? Does it have an exit strategy or wealth transfer strategy? Businesses are like marriages; easy to get into, hard to get out. Add this to the plan.

The reasons for financial planning are-

Goals and Objectives

Define your goals and objectives, determine your current position and discover unmanaged risks. This sounds simple and makes sense, but defining goals and objectives is a fluid concept. They change. And as they change, the plan needs to be malleable enough to adapt. Financial plans are modified annually or whenever a major life change as occurred, whichever is more frequent. This is important.

The Plan

Financial plans also create a blueprint and chart a course on how to reach goals and objectives while managing risk. Again, this sounds simple. But even the most basic house needs a blueprint for framers, plumbers, electricians and even inspectors to review and implement. And in the case of a financial plan, these same players are your financial advisors, tax professionals, attorneys and insurance specialists.

Accountability

Financial plans also provide confidence, measure success and hold everyone accountable. If everyone agrees that your financial plan will ensure financial security in your life, then it becomes a measuring stick for determining success along the way. Anyone can throw some money at an investment, but what does it mean? And does it fit the plan? And is the selection of that investment meeting the plan’s objectives.

WCG CPAs & Advisors can always assist you with retirement and financial planning as it relates to your small business and taxation. If you need a referral for a financial advisor, we might be able to help with that too. However, we have fallen out of favor with a lot of the assets under management fee schedules, so we have trouble endorsing an advisor since most charge a percentage based on your asset values. We are not quite sure how the size of your portfolio translates into time and expertise, and in turn the value for services provided, but we digress.

Small Business Retirement Plans Comparison

We are going to put the carriage in front of the horse, and show you a comparison of basic small business retirement plans before explaining each plan. We cheated, and used Pacific Life’s online calculator to demonstrate these differences. Why re-invent the wheel? And frankly, they do a fantastic job at this type of stuff. Here is their link-

wcginc.com/6103

We took a handful of salaries (for corporations including S corporations) and net incomes (for sole proprietors and partners in partnerships) and plugged them into Pacific Life’s calculator, and came up with the following table based on the 2026 tax year limits-

Salary/Income	Entity	Max 401k	Max SEP IRA	Max SIMPLE
60,000	Sole Prop / Partner	35,200	11,200	18,800
60,000	Corporation	39,000	15,000	18,800
125,000	Sole Prop / Partner	47,800	23,300	20,800
125,000	Corporation	55,250	31,250	21,750
150,000	Sole Prop / Partner	52,500	27,800	21,600
150,000	Corporation	61,500	37,500	22,500
190,000	Sole Prop / Partner	59,800	35,900	22,700
190,000	Corporation	71,000	47,500	23,700
250,000	Sole Prop / Partner	71,000	48,500	24,600
250,000	Corporation	71,000	62,500	25,200
285,000	Sole Prop / Partner	71,000	55,500	25,600
285,000	Corporation	71,000	71,000	26,300
372,000	Sole Prop / Partner	71,000	71,000	26,700
372,000	Corporation	71,000	71,000	28,500

Note the bolded $71,000 number. This is the maximum defined contribution amount permitted in 2026 per plan (and Yes, you can have two plans- we’ll talk about Greg and his two plans in an example later).

Crazy! The following are some quick observations-

• The maximum you can contribute to a qualified retirement plan is $71,000 for the 2026 tax year. You can go above this with a defined benefits pension (cash balance)- more on that later.
• Partnerships (those required to file Form 1065) follow the same limits as Sole Prop above.
• $190,000 in W-2 salary from your C Corp or S Corp is the magic number for maximizing your 401k. After that, any increase in salary does not help. Your fastest way to reach your contribution limit is through a 401k plan.
• $285,000 in W-2 income from your S Corp is the minimum salary for a max SEP IRA contribution.
• $372,000 from your small business or K-1 partnership income from your Schedule E as reported on your individual tax return is the magic number for maximizing your SEP IRA contribution. SEPs are old school and used for crisis management rather than planning (more on that too).
• Earned income from a sole proprietor is net profit minus 50% of your self-employment (SE) tax minus your contribution. Since the contribution actually adjusts the maximum contribution, this can be a circular reference. And No, 401k or SEP contributions do not reduce SE tax.
• 401k max is computed by taking $24,000 employee (you) contribution, plus 25% of your W-2 or earned income (as adjusted). This is for the 2026 tax year.
• SEP IRA max is computed by taking 25% of your W-2 or earned income (as adjusted).
• Max SIMPLE 401k is basically $17,000 plus 3% of your W-2 or earned income (as adjusted). Don’t spend too much time thinking about SIMPLE 401k plans.
• You can add $7,500 for catch-up contributions if you are 50 years old or older for the 2026 tax year.

Note: With the SECURE 2.0 Act, those aged 60-63 can do “super catch-up” allowing $11,250 versus $7,500 catch-up contributions into a 401k plan for the 2026 tax year. The $11,250 number is 150% of the regular catch-up limit, and in the case of a 401k plan, that is $7,500. If this should change, the super catch-up automatically adjusts.

Let’s talk about each of these qualified plans in turn, starting with the 401k. Out of the box, or non-traditional retirement plans will follow (profit sharing plans, defined benefits pensions, cash balance plans, Section 79 plans, etc.). Exciting!

By Jason Watson, CPA
Posted Monday, March 30, 2026

Rental property retirement planning might not be very exciting since most real estate investors and rental property owners view retirement through a lens of rental income and property appreciation rather than traditional investments in IRAs and 401k plans. However, from time to time, WCG CPAs & Advisors chats with a rental property owner who wants to contribute to a solo 401k plan.

The problem is simple- you generally need income that is subject to self-employment taxes (aka, Social Security and Medicare taxes). Rental income short of hotel-like operations is passive by nature and even with the short-term rental loophole or real estate professional status, it is not subject to self-employment taxes and doesn’t allow for a 401k contribution.

What can be done? You need to change the color of money. While most people want to go from earned income to passive income, you need to hit the cross-town traffic and go the other way.

Ok, Jimi, now what? You would charge your rental properties a management fee that is usual and customary. 5-10% for long-term rentals, and perhaps 20-40% for short-term rentals. This is paid like any other management fee where money is paid from the rental checking account to your management company checking account. From there, you can contribute to a solo 401k plan.

However, this quickly creates three potential problems-

• Depending on your state and regulated industry rules, you might have to register your management company. This might be extreme, right? You could also consider the payments from the rental properties to your management company as consulting fees.

• You are now paying self-employment taxes of 15.3% unnecessarily. As such, if your 401k investments have a rate of return around 7.5%, it will take two years to recover from this additional tax. 401k contributions only reduce income taxes, and not self-employment taxes. Sure, the tax deferral might mitigate this unnecessary tax expense, but it remains a tax deferral and not a tax deduction or avoidance technique.

• You might easily run into a situation where your management fee or consulting fee creates a rental loss. However, that loss might be limited based on passive activity loss limits. The problem is that you are recognizing income from the management or consulting fee, and it might be phantom income. Sure, you can reduce this with a 401k plan contribution and Yes, your passive activity losses will eventually offset future rental profits or release upon sale, but be aware of the corner you might be painting yourself into.

For the 2026 tax year, you contribute $24,000 plus $7,500 for catch-up (those 50 years or older) to a solo 401k plan. If you have multiple rental properties, each activity would pay a separate fee to the management company, and then in turn, the management company would make a 401k contribution.

Keep in mind there are two pieces to the 401k contribution puzzle- your contribution plus the company’s discretionary contribution. A $30,000 management fee would convert into $26,190 in total 401k contributions ($24,000 for the 2026 tax year plus 20% of net earnings which has special calculations) leaving some taxable income. A $23,500 management fee would convert into $21,940 leaving no taxable income after considering the self-employment tax deduction.

Sidebar: If you think you are clever and use a management fee as a way to get around passive activity loss limits, you’ll run into trouble. What are we talking about? You pay out a management fee, and deduct your travel, home office and all kinds of expenses on Schedule C, Profit and Loss From Business, of your individual tax return. Creating recurring losses on Schedule C could trigger an IRS examination under hobby loss rules.

Armed with all that, the rest of this chapter is aimed at retirement planning for the small business owner, or the collector of management or consulting fees. This is a truncated chapter. For a complete review of small business retirement including controlled groups, multi-member LLC 401k plans, and other issues, please see our other book, Taxpayer’s Comprehensive Guide to LLCs and S Corps.

By Jason Watson, CPA
Posted Monday, March 30, 2026

When you sell a rental property, either as an investment or as a business, you can invoke IRC Section 1031 to fully defer your capital gains tax including taxes associated with depreciation recapture, as long as you buy another similar property within 6 months. This is also called a like-kind exchange.

Do this right, and you can daisy-chain real estate investment transactions to avoid capital gains on real estate through your entire life, while enjoying the benefits of larger and larger incomes (the assumption is that you “1031” into larger investments with better cash flow, etc.). Said differently, your equity in the old property becomes the downstroke or down payment for the new property, and when leveraged correctly, you can quickly expand your buying power.

You can also view a portion of the down payment as an interest-free loan from the IRS. Huh? If you paid capital gains tax on the growth, your down payment is reduced by 15% to 23.8%. This can lower your purchasing power significantly assuming a structured purchase with equity and debt (mortgage).

Therefore, you can leverage 1031 like-kind exchanges to grow your rental property kingdom without having to pay taxes on the churn. What do we mean? If you wanted to get out of your Tesla stock position to dump money into Apple, you would pay capital gains taxes on your Tesla disposition along the way. Real estate property avoids this trap. This makes sense since real estate churn, if you will, invigorates the economy because so many players get paid within a transaction. Our tax code loves to encourage economic growth.

Let’s talk about purchasing power. By not having to pay taxes on your real estate gains, this ultimate increase in down payment can boost your purchasing power through leverage. In other words, what purchases more- $100,000 or $120,000 as a down payment?

This is overly simplified but highlights the objective. Scenario A is leveraging with a 1031 like-kind exchange while scenario B is leveraging after paying taxes along the way.

	Scenario A 1031 Exchange		Scenario B Paying Taxes
Single Family Home in 2020	350,000		350,000
Equity in 2025 (down payment + growth)	175,000		154,000
Down payment on 8-Unit in 2025	175,000		154,000
Purchasing Power @ 80% LTV	875,000		770,000
Equity in 2030 (down payment + growth)	393,750		308,000
Down payment on Commercial Property 2030	393,750		308,000
Purchasing Power @ 80% LTV	1,968,750		1,540,000

What happened here is that a real estate investor took $70,000 and purchased a single-family home in 2020. It grew in value, and the investor exchanged it for an 8-unit using the proceeds from the single-family rental property as the down payment for the next purchase. Lather. Rinse. Repeat.

We took some liberties on the growth factor, and for the “no 1031” column, we assumed a straight 20% capital gains tax rate. Your mileage might vary, but these calculations highlight the foundation of why a like-kind exchange is used.

Sidebar: Think of how much additional taxable revenue is created by encouraging real estate transactions with like-kind exchanges. Real estate commissions, title fees, inspection fees, among other triggered revenue, becomes taxable income of sorts for the IRS. Non-taxable transaction to you still generates a few tax bucks for the Treasury.

To top all this off, your heirs still get a full step up in basis upon your death under current tax law. Sounds easy, right? When’s the last time money was easy? There are some hurdles-

• Ineligible Property

• Deadlines (time) and spend (money)

• 1031 Exchange Qualified Intermediary

• Section 1245 property (cost segregation woes)

• State Issues

Ineligible Property

Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. In a like-kind exchange, both the real property you give up and the real property you receive must be held by you for investment or for productive use in your trade or business.

The rules for like-kind exchanges do not apply to exchanges of the following property-

• Real property used for personal purposes, such as your home.

• Real property held primarily for sale (think fix and flips, or home builder).

• Any personal or intangible property (but there is an exception for incidental property, keep reading).

The caveat of “investment or for productive use in your trade or business” is not super limiting. It is important, as we’ve seen in other sections of this chapter, for certain tax benefits involving passive activity loss limits.

Get a load of this- according to the IRS website, certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible for non-recognition of gain or loss as like-kind exchanges. What the heck is that? Colorado State University states, “A mutual ditch company is a private, voluntary, non-profit, fee-collecting entity. The company holds water rights, and members purchase shares in the company. Water is allocated annually by share, and shareholders pay assessments for company upkeep.” Who knew?

Can you exchange investment land for a building? Yes. But if that land was for your dream home initially, then it is unlikely eligible.

Can you exchange a U.S. property for a foreign property? No.

Can you exchange foreign property for another foreign property? Yes.

Can you exchange a property in California for one in Texas? Yes, but you have an annual California filing requirement.

Can you exchange oil and gas interests? Tenant in common interest in a real property? Yes and Yes.

Deadlines and Spend

Two definitions real quick- relinquished property is what you are selling, and replacement property is what you are buying. Rules to exchange by-

• Replacement property must be identified within 45 days.

• Replacement property must be purchased (fully closed) within 180 days.

• Replacement property should be of equal or greater value to the one being sold.

Identifying the replacement property must be handled correctly. Here is a blurb from IRS Fact Sheet 2008-18,

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.

Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.

Woah. Look at that last sentence. There is a maximum number of properties and value? Yes, there is! IRS Publication 544 Sale and Other Dispositions of Assets reads,

You can identify more than one replacement property. However, regardless of the number of properties you give up, the maximum number of replacement properties you can identify is:

1. Three properties regardless of their fair market value; or

2. Any number of properties whose total fair market value at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties you give up.

Fun!

1031 Exchange Qualified Intermediary

The intermediary can be a person, company, or other entity, but must not be related or married to the taxpayer. In other words, they must be professionally detached and disinterested in the transactions.

According to the IRS Fact Sheet 2008-18,

You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator.

The Fact Sheet also warns real estate investors of the possibility of the 1031 exchange qualified intermediary going bankrupt or being unable to fulfill the transaction leaving the investor non-compliant. Lovely.

Personal Property (Section 1245)

With the Tax Cuts and Jobs Act, personal property was excluded from being exchange eligible. Why do you care? With any real estate property transaction, inherently there is personal property being exchanged. Whether that is identified and valued usually depends on an existing cost segregation study of the relinquished property.

Let’s say you bought a $500,000 short-term rental and the cost segregation report came up with $80,000 in personal property eligible as 5- and 7-year property. Naturally, you accelerate depreciation of these items with bonus depreciation. Later, you enter into a 1031 like-kind exchange with another real estate investment property. Neat. However, a portion of your relinquished property is personal property, which is not eligible for tax-free exchange.

This could be a big deal, right? $80,000 in personal property associated with the rental that is fully depreciated and then later taxed at 37% marginal tax bracket upon depreciation recapture would be a $29,600 surprise tax bill. Wow, that’s a long sentence.

It is doubtful that the fair market value of the personal property would be $80,000 upon resale, but we still have a problem since there is some value. Also, land improvements, such as fences and sidewalks, or otherwise 15-year property, can be considered personal property (Section 1245) or real property (Section 1250) depending on the chosen method of depreciation.

What do you do? Historically, what rental property owners and tax professionals would do is assign ridiculously low fair market values to the personal property portion the transaction, recognize a little bit of depreciation recapture gain, and move along.

This would fail under IRS examination of course. In response, the IRS created a safe harbor of sorts that allows incidental personal property to be exchanged without this pesky depreciation recapture. Treasury Regulations Section 1.1031(k)-1(g)(7)(iii) reads-

(iii) Personal property generally resulting in gain recognition under section 1031(b) that is incidental to real property acquired in an exchange. For purposes of this paragraph (g)(7), personal property is incidental to real property acquired in an exchange if—

(A) In standard commercial transactions, the personal property is typically transferred together with the real property; and

(B) The aggregate fair market value of the property described in paragraph (g)(7)(iii)(A) of this section transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property or properties received in the exchange.

Cool. So, in using our example above, if you exchanged your rental property that is now worth $650,000 for another that has a fair market value of $800,000, you have a 15% x $800,000, or $120,000, cushion (ceiling) to the fair market value of the personal property being sold.

Another way to look at this- take the identified personal property’s fair market value in your relinquished property and divide that amount by the replacement property’s purchase price. This number needs to be 15% or less.

To recap- personal property is not eligible for a 1031 like-kind exchange unless it is considered incidental. To be incidental, it needs to be customary in a commercial transaction setting, or its fair market value needs to be 15% or less of the replacement property’s purchase price.

State Issues with 1031 Like-kind Exchanges

Every state is unique in terms of conforming to federal tax code. Let’s pick on California since it is an easy target. According to California’s instructions, in part, for 2023 California Form 3840,

In general, for taxable years beginning on or after January 1, 2015, California law conforms to the IRC as of January 1, 2015. However, there are continuing differences between California and federal law. When California conforms to federal tax law changes, we do not always adopt all of the changes made at the federal level.

The source of a gain or loss from the sale or exchange of property located in California is determined at the time the gain or loss is realized. The source of such gain or loss is preserved without regard to when such gain or loss may be recognized.

Form FTB 3840 must be filed for the taxable year of the exchange and for each subsequent taxable year, generally until the California source deferred gain or loss is recognized on a California tax return.

What does all this mean?

• California adopts federal tax code at its discretion. No kidding.

• The gain is computed when realized (time of sale) regardless of the gain or loss recognized in the future. This means you could have a taxable gain due to the California even if the eventual sale of the downstream property results in a loss.

• You must file California Form 3840 every year until the deferred gain or loss is recognized. You sell in 2026, and have zero footprint in California. You feel good. However, you will file FTB 3840 in 2026, 2027, 2028, etc. until some future sale triggers the recognition of a gain or loss for the 2026 transaction. Yay (not)! Also, FTB 3840 is a standalone form; it does not require a complete California tax return (540, 540NR, etc.).

Realized and recognized are terms of art in the accounting profession. In accounting geek-speak, realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. Don’t get too hung up on this.

Again, every state is unique, and every like-kind exchange is equally unique.

Improvement 1031 Exchange

An Improvement 1031, often called a construction exchange, allows real estate investors to use sale proceeds to both purchase a replacement property and fund its necessary renovations or ground-up construction. This strategy is ideal when the purchase price of the new property is lower than the value of the asset sold, as it allows you to build out the remaining value to ensure a fully tax-deferred swap.

The primary challenge is that all improvements must be completed and the property must be transferred within the strict 180-day exchange window. Because you cannot simply take exchange funds to pay a contractor to build on land you already own without blowing the tax deferral, a Qualified Intermediary typically sets up an Exchange Accommodation Titleholder (EAT) to “park” the deed while the work is performed. In accordance with 1031 exchange basics, the total value of the improved property (purchase + reno) at the time of the deed transfer must be equal to or greater than the value of the original property sold.

Lazy 1031 And Tax Arbitrage

While a formal 1031 exchange is a classic deferral tool, its rigid timelines and strict intermediary requirements can sometimes feel like a straightjacket. Many savvy real estate investors are now opting for the “lazy 1031” as a flexible alternative to offset capital gains with significantly less red tape. This approach allows you to bypass typical pesky 1031 like-kind exchange rules.

By combining a new property acquisition with a cost segregation study in the same tax year, you can generate a hefty first-year depreciation deduction to effectively wash out the tax hit from your sale. The strategy becomes even more potent when you apply it to a short-term rental (STR) loophole situation or utilize Real Estate Professional Status (REPS).

The ultimate goal here is true tax arbitrage: paying the tax on the sale at preferential capital gains rates (max 23.8% with NIIT), while using the massive new depreciation deduction to offset your ordinary W-2 or business income at your highest marginal tax bracket (up to 37%).

Reverse 1031 Exchange

We don’t want to spend too much time on reverse 1031 exchanges. They are an important tool, and there are several qualified intermediaries who can further assist. The generalist gist is this- you purchase the replacement property first. It is amazing. It will add nicely to your real estate investment portfolio. You have a boat anchor to unload first, right? However, you don’t want to let this new property slip away. What do you do? Ergo, the reverse 1031 like-kind exchange.

All the same rules apply to a traditional 1031 like-kind exchange. The high-level process involves the use of an Exchange Accommodator Titleholder. This arrangement basically “parks” the replacement property until the relinquished property is sold, and the exchange loop can be closed.

These are tricky but also very powerful when timing and market conditions don’t exactly align and provide convenience to your real estate investment life.

721 Exchange

Under IRC Section 721, “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”

We won’t spend much time on these, but you should know that you generally exchange real estate property for units in a partnership entity. The entity is a real estate investment trust (REIT), which often holds real estate through an operating partnership known as an umbrella partnership real estate investment trust (UPREIT). Are there rules and hiccups? Of course!

Delaware Statutory Trusts (DST)

Like 721 exchanges, we won’t spend too much time on Delaware Statutory Trusts, but you should know they exist. A DST is a separate legal entity created as a trust under Delaware Statutory Law and allows you to co-invest with other investors in one or numerous properties. These are also called a DST 1031 exchange.

They can come to your exchange rescue in a handful of ways-

• You don’t have to personally qualify for the debt associated with the replacement properties.
• DSTs can help eliminate boot or other transaction inequalities.
• Since you can identify up to three replacement properties (transactions if you will), DSTs can serve as your backup plan and help meet 1031 like-kind exchange deadlines.
• Delaware Statutory Trusts are built for quick closes, and can spring you into larger investments that might be more stable.
• The income generated is passive income which can help offset other passive losses.

Not all that glitters is gold so careful research and planning is necessary. Here is a quick list of problems with DSTs-

• Lack of control. If you are hands-on investor, DSTs will blow you up. However, they usually have streamlined dispute resolution and generally do not require unanimous voting in favor of using a trustee or some other fiduciary relationship.
• Lack of liquidity. The common definition of liquidity is the ease with which an asset can be converted into cash quickly without significantly impacting the asset’s value.” DSTs are like a marriage- easy to get into, hard to get out.

Can’t get enough? Technically, a Delaware Statutory Trust is considered a security under federal securities laws. However, IRS Revenue Ruling 2004-86 reads that a beneficial interest in a DST is considered “like-kind” real estate.

Ok, we spent a bit more time than expected.

Tax Bomb

While it might go without saying, we feel compelled to remind real estate investors that 1031 like-kind exchanges can be a tax bomb down the road. Sure, if you never sell and your kingdom passes to your heirs, they will likely enjoy a step-up in basis which wipes out the deferred gains. However, if you look to sell a rental or two every so often to augment retirement income, the depressed cost basis from a series of daisy-chained 1031s could be a tax surprise.

Cost Segregation Study on Replacement Property

We don’t want to get far into the weeds on this, but there is something you should be aware of when you double stack your cost segregation reports. For example, let’s say you purchase a $200,000 rental property, and with accelerated depreciation your adjusted basis is $100,000. When you perform a cost segregation study on your replacement property, you might be limited. How?

Original Purchase Price of Relinquished Property (a)	200,000
Depreciation Taken (b)	100,000
Adjusted Basis of Relinquished Property (a – b)	100,000
Replacement Property Purchase Price (c)	400,000
Assumed Net Cash Paid in 1031 Exchange (e)	200,000
Adjusted Basis of Replacement Property (a – b + e) (f)	300,000
Adjusted Basis of Replacement Property (f)	300,000
Replacement Property Purchase Price (c)	400,000
Allowable Cost Seg Ratio (f divided by c) (g)	75%

Our apologies if this blows things up a bit. The big takeaway is that your adjusted basis of the replacement property is based in part on the relinquished property. From there, a ratio is derived by comparing the adjusted basis to the overall purchase price of the replacement property. In the example above, a ratio of 75% is indicated.

When you perform a cost segregation study on the replacement property, and nice little buckets of 5-, 7- and 15-year property are detailed, you will apply the cost segregation ratio to determine a limit like so-

	5-Year	7-Year	15-Year
Cost Segregation of Replacement Property	25,000	15,000	30,000
Allowable Cost Seg Ratio (g)	75%	75%	75%
Allowed Property Value per Cost Seg Ratio Limit	18,750	11,250	22,500

Revenue Procedure 2008-16

1031 Like-kind exchanges are lovely tools to kick the tax bill down the road, and whenever there is free money, or at least the perception of free money, the gamers spring into action. What if you could exchange your vacation or second home by calling it an investment property? That would be amazing, right?

In IRS Revenue Procedure 2008-16, coming off the heels of Moore v. Commissioner, T.C. Memo. 2007-134, the IRS stated-

In Moore v. Commissioner, T.C. Memo. 2007-134, the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both were used by the taxpayers only for personal purposes. The taxpayers claimed that the exchange of the homes was a like-kind exchange under § 1031 because the properties were expected to appreciate in value and thus were held for investment. The Tax Court held, however, that the properties were held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”

As such, the IRS came up with some rules. Frankly, they are quite easy to comply with and offer some flexibility. To comply with IRS Revenue Procedure 2008-16, the vacation home (relinquished property)-

1. Must have been owned by the taxpayer for at least 24 months prior to the 1031 like-kind exchange (the “qualifying period”).

2. Must have been rented for at least 14 days (at fair market rates) in each of the 12-month periods immediately prior to the exchange.

3. Was not used for personal purposes for more than 14 days or 10% of the number of rented days at fair market rates (whichever is greater) during each of the 12-month periods.

Some notables-

• Must be rented for at least 14 days in each year; not just one of the years.

• The language reads 14 days or 10% of the actual rented days. So, if you rented the property out for 200 days at fair market rates, you could use it personally for 20 days.

• The replacement property (the acquired property) follows similar rules for the next 24 months.

The IRS states in their IRS Revenue Procedure 2008-16 that they will not challenge the validity of the 1031 like-kind exchange if real estate investors follow this mini safe harbor. How nice!

Pulling Money Out Your 1031 Like-Kind Exchange

The problem with selling a real estate investment and performing a 1031 exchange is that your equity is all tied up in the property or series of properties. If you directly take cash out of the deal then this call boot, and is likely taxable income (although there might be some thoughtful tax planning benefits that we discuss in a bit).

What can be done? Once the exchange is completed, you can refinance the debt on the replacement property to pull out cash. You might subscribe to equity stripping to lower your liability exposure or you might want to deploy that cash into other investments. Cash is king, right?

If you are not a big fan of taking on more debt, you can also run a parallel system. This works in either a debt reduction or a cash-out refinance situation. How this works is simple- you keep the cash safely invested at a rate of return that is similar to your cost of debt. At any point where you are not comfortable with the debt or you are not finding better alternative uses for the cash, you can pay down or pay off the loan. We say “similar to your cost of debt” since you don’t have to completely cover the cost of debt; having options is nice and it might be alright to pay a little extra to have those options. Buy comfort.

Keep in mind that you will need enough income to service the debt. Also, WCG CPAs & Advisors recommends not refinancing the relinquished property prior to the 1031 like-kind exchange. This might appear like an end-around to pull cash out of the exchange transaction which is frowned upon by the IRS.

Thoughtful Tax Planning with 1031 Exchanges

There are two scenarios where a 1031 like-kind exchange might not be the ideal tax planning move. First, let’s say you have passive activity losses that are being carried forward from the rental property itself or from other similar passive activities (such as other rentals or rental property investments), or both.

By selling outright, your capital gains might be sheltered with related passive activity losses plus you have direct access to the cash. This can be viewed in a similar vein to cost segregation where the play is to accelerate your access to cash. Time value of money type stuff.

The other scenario is similar and involves long-term capital gain losses either from prior year carryovers or current year transactions. Let’s say you sold some stock a bit ago at a significant loss. This loss carryover gets chipped away at $3,000 per year or when you have other capital gains. For example, you have $250,000 in long-term capital loss carryover. If you did nothing, it would take 84 tax returns to completely absorb these losses. Barf.

Alternatively, you could skip a 1031 exchange altogether or structure it carefully to throw some capital gains against your $250,000 loss carryover. You might still have depreciation recapture, but it might be a small price to pay for tax-free access to the remaining cash.

Deferring capital gains is always an objective, but it must be met with careful tax planning if you have passive activity losses or long-term capital losses, or both. WCG CPAs & Advisors recommends a comprehensive tax plan showing the depreciation recapture and capital gains effects before considering a 1031 like-kind exchange. Gain knowledge. Be informed. Make decisions.

Problems with 1031 Exchanges

There are a bunch of considerations when contemplating a 1031 like-kind exchange-

• If you are selling the property at a loss, you might be better to take the depreciation recapture hit today, regroup and move along.

• Feeling the massive pressure to identify the replacement properties within 45 days and then actually purchase one of them can be a lot. You might make a bad choice by either buying a lousy asset or paying too much, or both, because of the time pressures. The “gotta buy something” is not a good feeling and rarely yields a good result.

• Owning the relinquished property in a business entity and buying the replacement property in your personal name, or vise-versa, can invalidate the exchange. The tax identity must be maintained from the relinquished property ownership to the replacement property ownership. This can be a problem where you own a property in a partnership such as a multi-member LLC and you title the replacement property as tenants in common (TIC) with each named member of the former LLC. The like in like-kind extends a bit to the ownership as well.

Summary of 1031 Like-Kind Exchanges

Here is a nice summary to wrap up this section-

• Entire 1031 exchange process must be completed with 180 calendar days including holidays, weekends and astrological anomalies.
• Relinquished property is sold on day 1 and funds are held by qualified intermediary.
• Identify replacement property or properties (generally up to 3) by day 45 and notify the qualified intermediary.
• Close on all replacement properties by day 180.
• Maintain equal or greater amount of equity.
• Maintain equal or greater amount of debt.

By Jason Watson, CPA
Posted Monday, March 30, 2026

We get asked often, “What do you need to prepare my rental property tax returns?” Or, “what should I be recording or keeping track of throughout the year?” We created a template called the Simplified Rental Operations (SRO) Worksheet. While spreadsheets and templates are only meaningful to the spreadsheet designer, you might find value and some helpful hints.

Here is the link to our SRO-

wcginc.com/31

WCG Fee Structure

We pride ourselves on being transparent and having a simple fee structure. Most business services and tax returns will fit into the fees described below. Sure, there’s always the outlier or the unusual situation, but the following information gives you an idea of our philosophy. We only have time on this earth to sell, and we cannot inventory it. Our fees are an attempt to coincide with expected time spent and the value received.

As with anything in life, things change, so please refer to our most recent fees on our website-

wcginc.com/fee

And specifically our rental property tax return preparation page-

wcginc.com/rental

By Jason Watson, CPA
Posted Monday, March 30, 2026

Another twist. Let’s say you have a side business and a regular W-2 job where you max out your deferrals into the 401k plan. You cannot make employee deferrals to your side business solo 401k plan since you are collectively limited to $24,000 (for the 2026 tax year) or $31,500 with catch-up, but your business can make a discretionary non-elective contribution. Keep in mind that the total combined employee and employer contributions are capped at $71,000 for the 2026 tax year, with an additional $7,500 catch-up contribution allowed if you are age 50 or older.

Here is the word for word example from the IRS using 2016 limits of $18,000 as an example (occasionally they illustrate things well)-

Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer’s 401(k) plan for 2016, $18,000. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $18,000.

He has enough earned income from his business to contribute the overall maximum for the year, $53,000. Greg can make a non-elective contribution of $53,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer’s plan because the limit on annual additions applies to each plan separately.

Good ol’ Greg. From the employer or business perspective, a discretionary non-elective contribution is in contrast to a matching contribution. This means that a contribution can be without the employee making a deferral. This is key since in the tidy IRS example above, Greg has max’d out his deferrals at his regular job, so he cannot make additional deferrals with his side business. However, the business can make a non-elective contribution.

A non-elective contribution means that the business’s contribution is not dependent on the employee’s deferral. Seems counter-intuitive. In other words, you do not put anything into the 401k plan, but your business can contribute up to 20% of your income from the business as a garden variety LLC (or 25% of your W-2 from your business if electing S Corporation status). These are also referred to as discretionary contributions.

Sidebar: The phrase profit-sharing contributions is sometimes used as well. However, this is like interchanging 401k and IRA. Technically, a profit-sharing plan is different than a 401k plan, and it can either be standalone or deployed in combination with a 401k plan.

Therefore, if a company has excess profits (cash) and wants to make a contribution to the 401k plan, these are considered discretionary non-elective contributions and not profit-sharing contributions. This is because a 401k plan is being used and not a profit-sharing plan. Our apologies for splitting hairs and getting all nerdy on the nomenclature.

In summary, the $24,000 (for the 2026 tax year) limit is your limit as a person. But each 401k plan has a limit of $71,000 (see the last line of the IRS example on the previous page using 2016’s limits) which can add a lot of muscle to your self-employed retirement plan.

No, you cannot add your W-2s together (main job and side job) and use that for the basis of your side job / business employer contribution. That would be nice though.

Warning! Each year a handful of small business owners neglect to let us know they picked up W-2 income on the side, and they also forget to inform us that they contributed to their “side W-2 gig’s” 401k plan. Yes, we ask. We ask often. Therefore, keep in mind that the $24,000 deferral limit into a 401k plan (for the 2026 tax year) is for all plans, combined.

By Jason Watson, CPA
Posted Monday, March 30, 2026

Two arguments abound when considering a pre-tax 401k contribution. The argument goes like this- your retirement tax rate will be lower than your wage-earning tax rate. For those in the 32%, 35% or 37% marginal tax brackets, this is likely true. However, those earning big bucks probably continue to earn big bucks during retirement from investments, real estate, consulting, etc.

The other argument is about the free loan from the IRS. If you contribute $31,500 ($24,000 + $7,500 catchup for the 2026 tax year) to your pre-tax 401k and you are in the 32% marginal tax bracket, you just put $10,080 in your pocket ($31,500 x 32%). Another way to look at this is that $31,500 only took $21,420 in cash.

Sure, at some point the IRS wants it back when you withdraw it during retirement and will tax the original contribution plus whatever you earned on it. But this might fall into the let’s worry about next time, next time category.

As such, the second argument is about using the IRS’s money to build additional wealth. You take your $10,080 and do something good with it. Yeah, this argument sort of works. $10,080 annually might not move the needles much on your wealth building strategies. You would need $10,080 x 10 years at 6% rate of return just to afford a down payment on an average rental property.

Rather, most wealth is built with after-tax dollars. The leveraging of the IRS free loan concept sounds great on paper until you gain perspective on the size of the lever.

Another side argument is completely avoiding state income taxes by reducing your state income and therefore income tax with 401k contributions during your wage-earning years, and then establish residency in a tax-free or a tax-friendly state during retirement.

The theories above make sense; however, we ask a basic question- is it easier to pay taxes during your wage-earning years or during retirement? Sure, it depends how much you withdraw during retirement. Please consider that to spend $150,000 during retirement, you might have to withdraw upwards of $180,000 to account for the income taxes.

During your wage-earning years you might have the ability to work a little harder to pay for taxes now. Pick up an extra shift. Close an extra deal. Get a few more tax returns out of the door if you are a tax accountant. Whatever it takes, right? During your retirement years, especially mid-70s or older, you pay taxes with retirement savings (or at least it feels like you do depending on your cash sources).

Also, keep in mind that your primary objective in life is to build wealth. Your second objective is to save taxes, and what a lot of people forget about is saving taxes is not done in a vacuum or just one year; it is done over your entire lifetime.

Finally, consider that the law of 72 suggests that your investments will double every 8 years. Huh? The average rate of return for the S&P 500 is 9.2% since inception. If you take 72 and divide it by 9 (the rate of return) this equals 8, and suggests that your investment will double in 8 years. Where are we going with this? If you have 2 or 3 “doubles” coming up, to have that growth be tax-free upon retirement might be nice.

As mentioned elsewhere, WCG CPAs & Advisors recommends financial planning by a qualified planner to determine your objectives and model your particular scenario.

By Jason Watson, CPA
Posted Tuesday, March 24, 2026

You can elect to group all your rental properties into one activity so the material participation test is less onerous. If you had three rentals and were needing to use the 500 hours test for material participation (test #1), you would need to spend 3 x 500 or 1,500 hours total at a minimum.

Mechanics of the Election

The 1.469-9(g) election is a formal election on the tax return that endures each year unless revoked. Here is Treasury Regulations 1.469-9(g) which we broke up into bite size phrases-

(g) Election to treat all interests in rental real estate as a single rental real estate activity

(1) In general.

A qualifying taxpayer may make an election to treat all of the taxpayer’s interests in rental real estate as a single rental real estate activity.

This election is binding for the taxable year in which it is made and for all future years in which the taxpayer is a qualifying taxpayer under paragraph (c) of this section, even if there are intervening years in which the taxpayer is not a qualifying taxpayer.

The election may be made in any year in which the taxpayer is a qualifying taxpayer, and the failure to make the election in one year does not preclude the taxpayer from making the election in a subsequent year.

In years in which the taxpayer is not a qualifying taxpayer, the election will not have effect and the taxpayer’s activities will be those determined under § 1.469-4.

If there is a material change in the taxpayer’s facts and circumstances, the taxpayer may revoke the election using the procedure described in paragraph (g)(3) of this section.

Keep in mind the phrase “qualifying taxpayer” is synonymous with real estate professional. In other words, the 1.469-9(g) election is only for REPS.

What if you forgot to make this election? The IRS has provided relief allowing certain qualifying real estate professionals to make late elections to group all interests in rental real estate. IRS Revenue Procedure 2011-34 applies to a rental property owner who failed to file a timely election to aggregate but who has filed tax returns consistent with having made the election for all the tax years in question.

Is it an election to group or aggregate? A lot of subject matter material out there will use the word “group” but the IRS in their late election relief uses the word “aggregate.” Perhaps we can all agree to group real estate trades or business together for the 750 hours test and aggregate rental properties into a single activity.

Downsides to the 1.469-9(g) Election

Are there downsides to the election? Yes there are. The most impactful problem is the need for a material change before you can revoke the aggregation. If you cannot revoke the election, any combined suspended passive losses allocable to the rental real estate activities cannot be used to minimize capital gains. Piggybacking on the language from Treasury Regulations 1.469-9(g), the verbiage continues with-

(2) Certain changes not material.
The fact that an election is less advantageous to the taxpayer in a particular taxable year is not, of itself, a material change in the taxpayer’s facts and circumstances. Similarly, a break in the taxpayer’s status as a qualifying taxpayer is not, of itself, a material change in the taxpayer’s facts and circumstances.

Is selling one rental out of three material? How about two out of three as Meatloaf sings? Yes, since you no longer have a group, right? How about three out of five? Makes you wonder. There are other issues as well, but the material change requirement for revocation is the most prominent. This becomes problematic when you have unallowed losses being carried over on Form 8582, and you want to use them upon sale of a rental property.

Having said that, most real estate investors will worry about next time, next time, and will elect to aggregate to ensure material participation is met.

You cannot pick and choose which rental properties to group for material participation. The verbiage under 1.469-9(g)(1) above should be enough, but the Treasury Regulations 1.469-9(g)(3) continues with-

(3) Filing a statement to make or revoke the election.
A qualifying taxpayer makes the election to treat all interests in rental real estate as a single rental real estate activity by filing a statement with the taxpayer’s original income tax return for the taxable year.

Read the “treat all interests in rental real estate” part again. If you cannot get enough, IRS Revenue Procedure 2011-34, which outlines how to make a late 1.469-9(g) election as described previously, reiterates the “all interests” phrase again-

03 Relief for late election under § 1.469-9(g). The Service will notify the taxpayer upon receipt of a completed application requesting relief under this revenue procedure that satisfies the procedural requirements under section 4.02 of this revenue procedure. Any taxpayer receiving relief under this revenue procedure is treated as having made a timely election to treat all interests in rental real estate as a single rental real estate activity as of the taxable year for which the late election was requested.

In the span of two subparagraphs of tax code plus an IRS Revenue Procedure, the phrase “all interests in rental real estate” is used five times. There you have it- no pick and choose. All in, or nothing. It reminds you of My Cousin Vinnie- “You were serious about that?!” Yes, apparently.

Using the 500 Hours Material Participation Test with 1.469-9(g)

A lot of rental property owners cannot substantiate or even justify 500 hours spent on their rental property to meet material participation. As such, they revert to the thresholds of either a) 100 hours and more than anyone else, or b) substantially all hours. However, these are problematic because you must track other people’s time.

How do you know if your hours are more than anyone else’s? How do you know if your plumber had enough hours to make your substantially all hours moot or unavailable as you scramble to hit 100 hours?

The 500 hours material participation test is the hammer- it does not care about anything other than your time. If you have one rental, Yes, this is mostly unavailable even in a short-term rental situation (10 hours a week… every week… might be a stretch unless you have a project or something).

However, if you own two rentals, three rentals, or more, and you elect to aggregate them for material participation purposes, the 500 hours test cuts down on the chore of tracking everyone else’s time and time spent on each rental property. Less recordkeeping is good- as you know or will learn, a lot of taxpayers have a good tax position but cannot prove it with proper recordkeeping. Less recordkeeping burden is less risk.

Amending Tax Returns For REPS

Real estate investors often believe that if they missed claiming Real Estate Professional Status (REPS) on a previous tax return, the opportunity is lost forever. While you can technically file an amended tax return to claim the status, the real hurdle is the “aggregation election,” which allows you to treat multiple rental properties as a single activity.

Historically, the IRS required this election to be made on an original, timely filed tax return, with limited relief available only through specific procedures. This usually left those who missed it with a portfolio of separate activities that rarely meet material participation tests on their own. Fortunately, Revenue Procedure 2011-34 provides a path for investors to make a late aggregation election.

To qualify for this relief, the investor must have filed all required returns consistently with the requested treatment and must have a reasonable cause for the initial failure. Specifically, Section 4.02 of IRS Revenue Procedure 2011-34 reads-

The taxpayer must attach a statement to an amended return… stating that the taxpayer is making an election under § 1.469-9(g)(1) and identifying the taxable year for which the late election is to be effective.

From there the procedure details out five elements including reasonable cause. “I found a better tax strategy with a cost segregation study” is not a reasonable cause. “My tax professional made a mistake, and I relied on that advice” is more plausible.

By Jason Watson, CPA
Posted Sunday, March 22, 2026

If you meet the 750-hour requirement and more than half of your personal services are performed in real property trades or businesses, you qualify as a real estate professional. However, and as a reminder, to have your rental activities be considered nonpassive (so your rental losses are nonpassive), you must materially participate in your rentals. Yes, this is nuanced.

For example, many licensed real estate agents can easily satisfy the REPS hours test for being a real estate professional. However, they might not spend enough time on their own personal rental properties or rental activities, and therefore cannot prove material participation (MP hours).

Material Participation Trap

As we’ve mentioned a whole bunch, do not confuse your 750-hour REPS eligibility test with the material participation test for a specific rental property. Time spent acquiring a property can generally counts toward your overall 750-hour REPS threshold, but it does not count toward the hours needed for material participation on that specific property until it is placed in service.

There is, however, a critical material participation exception for real estate investors who are expanding an existing rental portfolio. If you make the formal election under Treasury Regulation Section 1.469-9(g) to treat all your rental real estate interests as a single activity, the landscape changes in your favor.

Why? Courts often view acquisition work as preliminary investment activity rather than participation in an existing rental activity unless the taxpayer has grouped their rental properties into a single ongoing activity.

Because the aggregated single activity is already a going concern, the time spent shopping for and acquiring a new property is viewed as expanding an existing business rather than starting a new one from scratch. In this grouped scenario, your acquisition hours may count toward material participation in the grouped activity and also count toward your 750-hour REPS requirement.

Spouse Hours For Material Participation

Spouses cannot combine hours to satisfy the 750-hour real estate professional test. Got it.

However, both spouses can contribute to the material participation requirement. Your spouse could be the 750 big shot and throw a hammer from time to time on your gaggle of rental properties. You can splash some paint on the walls as well. Both the hammer and the paint count for material participation for your spouse’s ability to materially participate in the rental activities.

Regulations 1.469-9(g) Election for REPS

We discussed this in a previous section when reviewing material participation. Here is a brief summary again-

You can elect to treat all your rental real estate interests as a single activity so that material participation is measured across the entire portfolio. If you had three separate rentals and relied on the 500-hour material participation test, you would need to satisfy that test for each property individually. That’s 1,500 hours total at a minimum.

The Treasury Regulations Section 1.469-9(g) election is a formal election on the tax return that endures each year unless revoked.

Sidebar: There is another sliver of business activity where the average guest stay is 30 days or less and you provide significant personal services such as daily linen changes, concierge services, bed and breakfast arrangements, etc. We won’t muddy the waters with that here, but it’s worth noting that the 7-day rule isn’t the only exception to the grouping party.

However, and this is a big deal, you generally cannot group short-term rentals with average guest stays of 7 days or less with traditional rental real estate activities (such as your mid-term and long-term rentals). Wait, what? Short-term rentals, as defined just now, are not considered rental activities under Treasury Regulations §1.469-1T(e)(3)(ii). In other words, you cannot mix apples and oranges with this grouping election. Group short-term rentals for STR loophole, and group other rentals for REPS.

Are there other downsides to the election? Yes there are. Again, please check out the section above. There is a ton more to it than what we listed here.

Material Participation Time Examples

See our material participation time examples section or a list of tasks and efforts spent on your rental property that count for REPS material participation.

By Jason Watson, CPA
Posted Sunday, March 22, 2026

Short-term rentals with average guest stays of 7 days or less create an odd technical problem for the 750-hour test because the regulations state they are not considered rental activities. Wait, what? It’s true! But there is an escape hatch at the end. Stay with us for a bit.

Treasury Regulations Section 1.469-1T(e)(3) reads “an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year the average period of customer use for such property is seven days or less.”

Sidebar: Don’t confuse tangible property with personal property. Real property is tangible property since you can touch it, paint it, etc. Technically, tangible property has physical substance.

Read those last two sentences again. Are we telling you that a short-term rental with an average guest stay of 7 days or less is not considered a rental activity? Not even a real property trade or business for purposes of the passive activity rules? No, but the regulations are.

Oh, and so are the courts.

In Bailey v. Commissioner, Tax Court Memo. 2001-296, and again in Bailey v. Commissioner, Tax Court Summary Opinion 2011-22, which are different people with different facts but the same problem- the court used a literal interpretation of “the average period of customer use for such property is seven days or less” and stated that the activity was not a rental activity, and therefore the taxpayers could not rely on those hours to establish material participation.

The reasoning in both Tax Court decisions has been criticized because the analysis relied heavily on the formal election under Treasury Regulations Section 1.469-9(g) to group all rental activities into one activity for the primary purpose of demonstrating material participation. However, grouping activities for the 750 hours test does not rely on the formal election to group rental activities. We are getting a bit into the weeds.

The bad news is that courts have sometimes refused to count hours from short-term rentals with average stays of 7 days or less toward the 750-hour requirement. The good news is that these short-term rentals are typically not treated as rental activities and sidestep passive loss limitations. However, if you have a mixed bag of real estate investments, this potentially flawed Tax Court logic could become problematic.

Sidebar: Keep this 7 days or less thing in mind. Also, keep in mind that rental properties are presumed to be passive. The foundation of the short-term rental ‘loophole’ is that the activity is not classified as a rental activity because of the 7 days or less average guest stay. More on that in our short-term rentals section.

If you cannot get enough, here is a contradicting blurb from Chief Counsel Advice 201427016–

whether a taxpayer is a qualifying taxpayer within the meaning of section 469(c)(7)(B) and Treas. Reg. § 1.469-9(b)(6) depends upon the rules for determining a taxpayer’s real property trades or businesses under Treas. Reg. § 1.469-9(d), and is not affected by an election under Treas. Reg. § 1.469-9(g). Instead, the election under Treas. Reg. § 1.469-9(g) is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.

Let’s break this down. IRC Section 469(c)(7)(B) refers to the 750 hours requirement. The Treasury Regulations 1.469-9(g) refer to the formal election to group all your rental activities together as a single activity for material participation testing. The Chief Counsel Advice suggests a different analytical approach than the one used in the Bailey decisions. Nice!

In other words, the IRS clarified their version of chicken and egg sequencing problem. The formal election under Treasury Regulations 1.469-9(g) to group rental activities together is typically considered after qualifying as a real estate professional. If you cannot or choose not to elect your rental properties under the 1.469-9(g) regulations, it should not be used as a wedge to unravel your grouping of all real property trade or businesses for the sake of the 750 hours test.

Tilt!

Could you make a reasonable argument that you are relying on Chief Counsel Advice 201427016? Perhaps, but this area remains unsettled.

How about this angle?

Treasury Regulations Section 1.469-1T(e)(3) merely states that short-term rentals with an average guest stay of 7 days or less are not considered rental activities. Got it. Beat up. Can’t forget. Like ever.

However, IRC Section 469(c)(7)(C) defines a real property trade or business much more broadly to include development, construction, acquisition, operation, management, leasing, and brokerage. Focus on operation and management for a minute.

In other words, an activity can fail the definition of a rental activity and still potentially qualify as a real property trade or business. As such, some practitioners, and WCG CPAs & Advisors tends to agree, argue that time spent operating or managing a short-term rental could still count toward the 750-hour requirement, even though the activity itself is not treated as a rental activity.

Essentially, the accounting industry, courts, and the IRS at times treat real estate professional status as if it applies only to rental real estate, when the statute actually refers more broadly to real property trades or businesses. A hotel is not rental real estate, we can all agree. However, a hotel is certainly a trade or business using real property.

Finding cracks and splitting hairs.

By Jason Watson, CPA
Posted Sunday, March 22, 2026

While bonus depreciation usually grabs the headlines, IRC Section 179 is the workhorse of small-to-mid-sized real estate. For rental properties under $5M, cost segregation typically identifies 20% to 40% of the basis as eligible property (5-, 7-, or 15-year assets). Since the Section 179 limit is $2,560,000 for the 2026 tax year, it effectively covers the entire amount of property eligible for acceleration (and perhaps even higher than a $5M purchase).

The critical distinction is intent:

• Bonus Depreciation is an automatic loss generator. It can drive your business income into the negative, creating a Net Operating Loss (NOL) that can offset your W-2 income, subject to excess business loss limitations (EBL) and other restrictions.
• Section 179 is an elective profit killer. It is limited by your taxable income, which can restrict how much you can use in a given year. This makes it feel weaker federally, but far more powerful at the state level. And No, you don’t have to wait long for us to explain.

The State Conformity Battleground

This is where Section 179 shines. Most states are decoupled from bonus depreciation- meaning if you take a $500,000 bonus deduction on that massive cost segregation study on that equally massive rental property, your state makes you add it back (literally or figuratively depending on your state) and pay state tax on it today. However, a significant majority of states conform to federal Section 179 limits.

Sidebar: As of the 2026 tax year, these states generally roll with the federal Section 179 limits as of the 2026 tax year- AL, AZ, CO, DE, GA, ID, IA, IL, KS, LA, MA, ME, MI, MS, MO, MT, NE, NM, ND, NY, OK, OR, RI, SC, UT, VT, VA, WV. There are some developments with AZ.

Sidebar #2: Some states have detachment anxiety but eventually compromise. California is the poster child—capping Section 179 at $25,000 and forcing a second depreciation schedule. Other states such as Arkansas, Hawaii, Indiana, Kentucky, New Jersey, and Pennsylvania also limit or modify Section 179 in various ways rather than fully conforming. Ohio allows Section 179 but requires adjustments that effectively spread the benefit over time. Maryland also imposes limits with additional modifications. Translation: same concept, different flavors of pain.

By using Section 179 instead of bonus depreciation, you achieve tax nirvana: a massive deduction that works for both federal and state tax returns simultaneously. Without 179, you might save 37% federally but still get nickeled and dimed by a 5% to 9% state tax on that same income. More like beaten with the dollars whip- forget about nickels and dimes!

Trapped Section 179 Deductions

Despite its state-level benefits, Section 179 has a locking mechanism when used inside a pass-through entity such as a multi-member LLC (MMLLC) taxed as a partnership. While the partnership allocates Section 179 deductions through the K-1, the deduction is first limited at the entity level based on the partnership’s business income. It is then subject to additional limitations at the partner level under IRC Section 179(b)(3), along with basis, at-risk, and passive activity rules.

If the partnership does not have sufficient income, a portion of the Section 179 deduction never makes it to your personal tax return in the first place. And if it doesn’t land on your Form 1040, it cannot offset anything including your W-2 income. Yeah, read that again. Buzzkill for sure.

As a result, even if the partnership generates a large Section 179 deduction, a partner with limited income might find the deduction effectively trapped, either at the entity level or on their personal return, and carried forward to future years. Possibly a lot of future years.

Sidebar: Think you can avoid a partnership return by assigning your LLC interests to a joint revocable trust? Think again. In common law states, the IRS disregards the trust and sees two distinct owners (the spouses) under IRC Sections 671–679, mandating a Form 1065 partnership filing per Treasury Regulations Section 301.7701-3. Unless you are in a community property state, you cannot bypass the partnership layer or report this activity directly on your Form 1040.

Bonus depreciation asks, “Did you place it in service?” Section 179 asks, “Do you have enough income to deserve it?” Yeah, Ok, animals can’t talk, we get it, but play along please.

Change in Use Clawback

Section 179 carries a “predominant use” sting that bonus depreciation (for non-listed property) largely avoids.

• Section 179 Recapture: If you convert your STR into a second home or primary residence, and as such business use drops below 50%, the IRS triggers an immediate recapture. You must pay back the benefit (the difference between the 179 deduction and standard MACRS depreciation) as ordinary income in the year of conversion. Yuck.
• Bonus Recapture: For IRC Section 1245 property (furniture, carpet, etc.), there is generally no immediate clawback just for taking down your Airbnb listing. The depreciation simply sits on the inactive activity’s depreciation schedule until you sell the property.

Granted, this is crystal ball type stuff. Then again, if 3-4 years go by, and then you want to take the short-term rental out of service and make it a second home, the decision you made way back when could haunt you.

The OBBBA Acquired Provision

The OBBBA introduced a specific hurdle for bonus depreciation- the “Acquired after January 19, 2025” rule. To qualify for 100% bonus depreciation, you must have acquired the property after that date.

If you bought a home in 2024 as a primary residence and are converting it to a rental in 2026, it was acquired prior to the OBBBA deadline. In this specific “primary-to-rental” conversion, bonus depreciation will be subject to pre-OBBBA rules or in this case 40%. Section 179 does not have this same “acquired” restriction, making it the primary viable path for a massive year-one deduction on older properties newly placed into service as rentals.

Section 179 Versus Bonus Depreciation Wrap-Up

Section 179 is the Swiss army knife of depreciation- it’s the best way to get a state-level deduction and the only way to handle properties acquired before the OBBBA. Its only real downsides are its inability to create a paper loss at the entity level and the aggressive recapture rules if you decide to move in.

Said differently- the question isn’t which deduction is bigger but rather which one survives all the limitations and rules, today and tomorrow. Yeah, Ok, that probably didn’t help much.

Let’s talk about mid-year conversions. What happens if you run a short-term rental (STR) for the first four months of the year, convert it to a long-term rental (LTR) for the remaining eight months, successfully treat them as two separate economic units on your tax return under Treasury Regulations Section 1.469-4(c), and then decide to do a cost segregation study?

Do you take the massive bonus depreciation deduction and slice it up by allocating 4/12ths to the STR and 8/12ths to the LTR?

No. You do not. And understanding exactly why is the difference between a massive tax refund and a massive tax trap. Oh, let’s not forget an incorrect tax return as well.

The Point-in-Time Rule

Bonus depreciation is not a monthly, prorated concept. It is a point-in-time deduction. It drops like an anvil the exact moment the property (or its cost-segregated components) is first placed in service for a business use.

Standard MACRS depreciation is prorated based on the applicable depreciation conventions and the portion of the year each activity operated, but bonus depreciation is claimed in full by whatever activity is happening on day one. Because of this, the order in which you operate the property dictates exactly which bucket that giant tax loss lands in.

STR First, Then LTR (The Winner)

Let’s say you place the rental property in service as an STR in January. You materially participate, manage the guests, and satisfy the 7-day rule. Do all the right things.

In May, you get tired of the turnover, or perhaps ski season is closing out, and lease it to a long-term tenant. Because it was an STR when it was first placed in service, the STR activity claims the entirety of the bonus depreciation. Assuming you materially participated, this creates a massive non-passive loss that can offset your W-2 or business income.

When the property converts to an LTR in May, it inherits the remaining, much lower adjusted basis. The LTR activity simply claims the standard, prorated MACRS depreciation on the leftovers for the remaining eight months.

Mechanically, there are a couple of things to keep in mind. First, you will list two activities on your tax return- one for the STR version and another for LTR version of the same actual real estate asset. Next, you will have two depreciation schedules as well, and the LTR’s unadjusted cost basis will be the STR’s original cost basis less whatever depreciation including bonus depreciation was deducted on that activity.

LTR First, Then STR (The Trap)

Now, let’s flip it. You place the property in service as an LTR in January. In May, the tenant moves out, and you decide to turn it into an Airbnb to hit the juicy summer travel traffic. You do a cost segregation study since now it qualifies as an STR and can deduct against your big W-2 income.

Because it was an LTR when it was first placed in service, the LTR activity claims the bonus depreciation. Unless you are a qualifying Real Estate Professional (REPS) or have other passive income, that massive cost segregation and subsequent depreciation loss drops straight into your passive bucket and gets trapped. Yuck.

When you convert to an STR in May, you might materially participate and run a great hospitality business, but the depreciation damage is done. Just like our other example, the STR activity only inherits the remaining adjusted basis and gets a tiny sliver of standard MACRS depreciation. The giant STR loss bomb you were hoping to trigger was already detonated in the passive bucket. Ok, that was a bit over the top, but whatever.

The Takeaway

If you are treating a mid-year conversion as two separate activities, there is no magic rule that lets you assign the bonus depreciation to the activity you prefer. It is strictly dictated by the placed-in-service date.

If your strategic intent is to use the STR loophole to offset ordinary income, the property must be placed in service as an STR first. Flipping an LTR to an STR mid-year mechanically works the same way, but strategically, it traps your best tax deductions behind the passive loss wall. Timing isn’t just everything; it is the only thing.

The Reboot Myth And The Entity Shuffle

Some clever real estate investor is inevitably going to ask: “Wait, if an STR is a totally different business than an LTR, why can’t I just take the LTR out of service, and then ‘re-place’ it into service a week later as a brand-new STR to grab the bonus depreciation again? Or better yet, what if I sell it to a new multi-member LLC I own with my spouse so a ‘new taxpayer’ buys it?”

Nice try, but the IRS saw you coming a mile away. You cannot unplug your rental property and plug it in somewhere else and reboot your tax deductions. Here is why the tax code crushes both of these maneuvers:

Under IRC Section 168(k), bonus depreciation is strictly a “first placed in service” deduction. The IRS only cares about the very first time you made that specific asset ready for any income-producing activity. Transitioning from an LTR to an STR is classified as a “Change in Use” under Treasury Regulation Section 1.168(i)-4. It may change how the property is classified for depreciation purposes, but it does not reset the original placed-in-service date.

Sidebar: The one exception? Brand-new assets you buy specifically for the STR, like a hot tub or new furniture. Those get their own fresh placed-in-service date and their own bonus depreciation. Yeah, this doesn’t make you feel any better.

If you try to outsmart the system by dropping the property into a new LLC with your spouse or your S Corp, you hit two brick walls:

• If you simply contribute the property to the new LLC, the entity “steps into your shoes” as suggested by IRC Section 168(i)(7). It inherits your exact depreciation schedule, remaining basis, and original placed-in-service date.
• If you actually sell the property to the LLC to claim bonus depreciation on “new to the LLC” property, you trigger related party transaction rules. Because you, your spouse, or your controlled entities own more than 50% of the new entity, the IRS disallows the bonus depreciation entirely, and you just triggered a taxable sale for absolutely no reason.

Here is the exact language of IRC Section 168(i)(7) which will completely put you to sleep:

(7) Treatment of certain transferees
(A) In general
In the case of any property transferred in a transaction described in subparagraph (B), the transferee shall be treated as the transferor for purposes of computing the depreciation deduction determined under this section with respect to so much of the basis in the hands of the transferee as does not exceed the adjusted basis in the hands of the transferor.

The house always wins. The asset keeps its original history, and the bonus depreciation clock does not reset.