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 Saturday, March 21, 2026

Personal use days are what you would expect but they also include days when you rent the property to others for less than fair rental price. Personal use days do not include any day that you spend working substantially full time repairing and maintaining your rental property.

Sidebar: Under IRC Section 280A(d)(2), you cannot rent to family members either. The same vacation home rules apply, and their days will count against your personal use days even if they pay fair market value rent. However, if they use the rental property as their primary residence and pay fair market rent, then family members are treated like any other tenant.

What about days where you are improving the property (recall the betterment, adaptation and restoration standards from our improvements versus repairs section)? This is a conundrum without clear answers. The sentence at the end of the paragraph above was ripped off from the IRS. It reads in full as-

Days used for repairs and maintenance.
Any day that you spend working substantially full time repairing and maintaining (not improving) your property isn’t counted as a day of personal use.

If you spend a week building a deck or remodeling a kitchen, those days are not rental days since the property is not available for rent. We can agree with that. But are they personal days? No, not necessarily.

In Van Malssen v. Commissioner, Tax Court Memo 2014-236, the Tax Court emphasized that the purpose of the stay is the primary factor in determining personal use. In other words, work is not leisure.

If you are actively working on the rental property hauling materials, managing contractors, or performing construction, it is reasonable to argue those days are not personal use, even if they do not fall neatly within the repair safe harbor (i.e., they go beyond honey-do chores on the rental property).

However, this position is not explicitly supported by statute or regulations. Unlike repair days, improvement days are not clearly excluded from personal use, which creates potential audit risk. As a result, these days occupy a gray area: not rental, not clearly personal, and highly dependent on facts and documentation.

Frankly, we are not sure why the IRS cares. It should come down to this- your butt is in the rental, is it for personal reasons or business reasons?

Assuming improvement days are neither rental use days nor personal use days, how does this impact you? In most cases, it doesn’t directly affect your rental-use percentage calculation, since that formula only considers rental days and personal use days. We discuss computing the percentage of expenses allowed as rental property deductions in more detail in a bit; for now, it is simply rental use days divided by the total days of use (personal + rented).

• Days spent improving the rental property do not impact this calculation. It could, however, if the tax code defined total days of use to include improvement days.
• Days spent repairing and maintaining the rental property also do not impact this calculation as personal use days.

Why did the IRS add the “(not improving)” qualifier then? No one knows. If they do, it is a well-kept secret.

Sidebar: Specifically for partnerships where two or more people own a rental property inside of an entity, and as far as we can tell from the tax code and other resources, each owner (partner) does not get a fresh set of 14 days or 10% rented days. That’d be nice, right? Rather, if owner A uses the property for 10 days, and owner B uses it for 9 days, this will be 19 days total.

By Jason Watson, CPA
Posted Saturday, March 21, 2026

It is common to have a second home that you rent out. It is also common to have a rental property that you use personally. It’s all a matter of perspective, right? One of the biggest reasons to have a mixed-use rental property, or what the IRS would call personal use of a dwelling unit or vacation home, is to defray costs of ownership. Said in another way, a vacation home can be a nice split between current-day lifestyle enhancements and long-term wealth-building.

According to IRS Publication 527 Residential Rental Property–

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

14 days, or

10% of the total days it is rented to others at a fair rental price.

If you trip these wires, the IRS considers the rental property (dwelling unit) a home. Why do you care about triggering these rules? If your rental property is partially considered to also be a residence (vacation home) then your expenses and therefore rental property deductions are limited. We’ll dig into what this means including the Bolton Tax Court case in a little bit

Let’s review the calculations first. You rent the property to others at a fair rental price for 67 days. The calculation above then becomes the greater of 14 days or 6.7 days. As such, you can use the property for 14 days as personal use and not trip the vacation home rules.

Another way to look at this- if you had 30 personal use days of your vacation home, then you would need to have rented it to others for 301 days or more. Why? You trigger the vacation home rules at the greater of 14 days or 10% of 301, or 30.1 days.

Let’s take a step back. There are two immediate questions. What is a day of personal use? What is fair rental price?

Fair Rental Price

This is typically not a tough question to answer. AirDNA, Airbnb and VRBO can quickly help determine the fair rental price for short-term stays. Zillow, Realtor.com and others can also quickly help with long-term leases. There are a zillion other tools that we are not mentioning. Here is the blurb from IRS Publication 527 Residential Rental Property–

A fair rental price for your property is generally the amount of rent that a person who isn’t related to you would be willing to pay. The rent you charge isn’t a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property in your area.

Ask yourself the following questions when comparing another property with yours.

Is it used for the same purpose?
Is it approximately the same size?
Is it in approximately the same condition?
Does it have similar furnishings?
Is it in a similar location?

If any of the answers are no, the properties probably aren’t similar.

Personal Use Days

We have a deep dive section on personal use days with your STR. However, here is a quick summary of the talking points-

• The limit. Personal use days cannot exceed 14 days or 10% of the fair rented days, whichever is higher.
• Repair days. Personal use days do not include days where you substantially full time doing repairs and maintenance including deep cleanings.
• Improvement days. Days spent improving the property are neutral days, where they are not considered personal or rented days which makes sense. These days also should not be included in the denominator of any percentage use calculation. This is not supported directly by statute or regulations, but it is supported by reasonable logic that we discuss later.
• Family rule. If you rent to your parents, siblings or children, even at fair market rental rates, these days are counted at personal use days unless the rental is being rented as a personal residence (think long-term).
• Friends rules aka the Homie hookup. If you rent to your friends at below-market rental rates, those days will also be considered personal use days. Ensure money moves las if you rented to a perfect stranger, but then spring for dinner and drinks when they get back.
• Lifestyle benefit. Personal use days are not necessarily bad and can be piggybacked onto repair or improvement days to create a lifestyle improvement or vacation or the hip word “workation.” For example, you spend 3 days painting, you can still enjoy sunsets and views of the lake after you put the paint rollers away. Tack on a few more days as personal days, and you’ve create a decent getaway while remaining compliant.

Again, see our personal use of your short-term rental section for more information.

Rental Property Expenses Are Limited

Let’s say you’ve determined that your personal use days exceed what is allowed and now vacation home rules apply. What are these silly rules anyway? IRC Section 280A(c)(5) reads in part-

(5) Limitation on deductions

In the case of a use described in paragraph (1), (2), or (4), and in the case of a use described in paragraph (3) where the dwelling unit is used by the taxpayer during the taxable year as a residence, the deductions allowed under this chapter for the taxable year by reason of being attributed to such use shall not exceed the excess of-

(A) the gross income derived from such use for the taxable year,

The first thing to do is calculate the rental use portion of the total days the property was used. Here is a table from a live WCG CPAs & Advisors client-

Personal Use Days	51
Rental Use Days	105
Total Days of Property Use	156
Rental Use Portion	67.3%
Personal Use Portion	32.7%

In this example, we will apply 67.3% to certain rental property expenses. However, there are several expenses that this rental use percentage will not be applied to-

• Mortgage interest and real estate property taxes, and

• Those expenses that are 100% attributable to renting the property such as advertising, management fees, commissions, and guest-related cleaning and supplies.

Keep in mind that you must count actual rental use days as opposed to taking 365 days and simply deducting your personal use days.

Tax Court Method

Under vacation home rules, the personal use portion of mortgage interest and real estate property taxes are deductible on Schedule A of your Form 1040 (individual tax return). However, if your rental property tax deductions are going to be limited, you want the highest personal use portion to be applied to mortgage interest and property taxes.

What do we mean here? Look at the table above again. In that example, the rental property was rented for 105 days which would suggest there are “260 days-worth” of mortgage interest and real estate property taxes attributable to personal use, or about 71.2%, and not 32.7%.

The IRS would rather have you use the lower percentage since a higher amount of mortgage interest and property taxes would be applied to the rental and therefore limited under the vacation home rules (and in turn, not deductible). Consider this table-

Mortgage Interest	20,238
Personal Use Portion (IRS Method)	32.7%
Amount Deducted on Schedule A	6,616
Personal Use Portion (Tax Court Method)	71.2%
Amount Deducted on Schedule A	14,416
Difference	7,800
Tax Rate	37%
Cash Savings	2,886

This is a big deal, right? It was for Dorance and Helen Bolton who owned a rental property in Palm Springs, California. In Bolton v. Commissioner, 77 Tax Court 104 (1981), the Tax Court stated-

Interest is an expense that accrues ratably over the year and property taxes may likewise be regarded as being applicable to the entire year. The ordinary and normal method of determining what portion of interest is allocable to any part of a year would be to multiply the annual interest by a fraction, the numerator of which is the number of days in the period involved and the denominator is the number of days in the year. The same process would be employed in respect of real estate taxes. It was this method that petitioner used in applying the limiting provisions of section 280A(c)(5)(B).

It continued to state-

In taking a different view, the Government utilizes the identical computation specified in section 280A(e)(1), in which it compresses the annual interest and property taxes into the 121-day period that the property was used. But while that computation may serve a useful purpose in respect of the otherwise nondeductible maintenance expenses that are ordinarily associated with occupancy or use of the property, entirely different considerations are involved in respect of items such as interest and taxes that are spread over the entire year and are deductible in any event.

What does all this mean? The Tax Court sided with Bolton who had basically computed a daily amount of mortgage interest and real estate property taxes, and deducted the amount associated with rental days from their rental income, and then deducted the remainder on Schedule A.

Sidebar: The Commissioner (IRS) appealed, and the United States Court of Appeals for the Ninth Circuit in 1982 affirmed the Tax Court’s decision.

As such, we now have a thing called the Tax Court Method and it is sometimes called the Bolton Method. A win for the taxpayer! The IRS really hated this loss. A lot.

The Vacation Rules Steps

There is an iterative process to determining the eligibility to deduct certain rental property expenses. Worksheet 5-1. Worksheet for Figuring Rental Deductions for a Dwelling Unit Used as a Home from IRS Publication 527 Residential Rental Property walks you through the process. We will try to simplify it here-

• Starting with gross rental income, deduct the allocated mortgage interest and real estate property taxes according to the Tax Court Method with the remainder being reported on Schedule A. Keep in mind that there might be additional limitations based on mortgage interest and state and local taxes (SALT) limitations, or what is called excess.

• Next, deduct direct rental expenses such advertising, management fees, commissions, and other expenses that are directly related to and generated from the rental days.

• Next, deduct allocated operating expenses such as insurance, repairs, utilities, etc. according to the rental use portion. Keep in mind that some of these expenses might have a direct component such as guest-related cleaning and commissions, and are therefore deducted at 100%. This will also include excess mortgage interest and real estate property taxes (however, these add-ons are not the personal use portion but rather limited by other tax code provisions).

• Next, if operating expenses based on the rental use portion exceed the remaining rental income after mortgage interest, property taxes and direct rental expenses, the calculated loss will be added to the carryover from prior years.

• Next, calculate the depreciation considering the rental use portion. If rental income remains after mortgage interest, property taxes, direct expenses and allocated operating expenses, then deduct the calculated depreciation. If this creates a loss, the calculated loss due to depreciation will be added to the carryover from prior years.

As such you can see, you could possibly be calculating two carryover amounts for future years: operating expenses and depreciation.

Here is the worksheet from our tax software for a WCG CPAs & Advisors real estate investor-

A few notables on this Vacation Home Worksheet-

• You will see the two methods for determining personal and rental use portions. The typical or IRS method showing 67.31% for rental expenses, and then the Tax Court Method showing 28.77% for mortgage interest and real estate property taxes.

• The inverse of these two percentages is 32.69% and 71.23% respectively. You will see those numbers used under the “Personal Usage” column.

• The taxpayer was limited on state and local taxes (SALT) and as such you don’t see an amount on line 2b.

• Cleaning, supplies and certain other expenses were allocated as 100% for rental property operating expenses. These could have been listed in line 2d.

• You will notice that operating expenses exceeded the rental income on line 3. As such, the carryover amount for future years is calculated by taking current operating expenses of $20,522 (line 4a, 4b and 4c) plus prior carryover amounts of $36,108 (line 4d) less the remainder of rental income of $20,495 (line 4f). This equals $36,135 is listed on line 7a.

You can see a PDF of this worksheet.

Keep in mind that these carryover amounts are not passive activity losses which are traditionally reported on Form 8582. Also, they cannot be used like passive activity loss carryovers upon sale. However, vacation home carryovers may be used when there is future rental income (profits).

By Jason Watson, CPA
Posted Saturday, March 21, 2026

A long-standing rule is passive activity losses that exceed the passive activity income are disallowed for the current year. You can carry forward disallowed passive losses to the next taxable year. This comes from IRC Section 469(d)(1) which reads-

Passive activity loss
The term “passive activity loss” means the amount (if any) by which-

(A) the aggregate losses from all passive activities for the taxable year, exceed
(B) the aggregate income from all passive activities for such year.

Neat. So, what is a passive activity? IRC Section 469(c)(1) lovingly reads-

Passive activity defined
For purposes of this section-

(1) In general
The term “passive activity” means any activity—

(A) which involves the conduct of any trade or business, and
(B) in which the taxpayer does not materially participate.

As such, rental property activities are typically considered passive, meaning that you are not directly earning the income as you would with a W-2 job or as a small business owner. Passive losses cannot be deducted from nonpassive income such as wages, portfolio income and business income.

We will discuss material participation in a moment and we dig into real estate professional status (REPS) later as well. Here is a big takeaway from the tax code- A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. Ok, now what? We’ll get to that in a minute.

There are exceptions where your activity is not considered a rental activity for the purposes of passive activity losses-

• The average period of customer use of the property is 7 days or less. You can rent anything, right? So, the IRS uses this cryptic language. In the context of rental properties, it means average guest stays of 7 days or less.

• The average period of customer use of the property is 30 days or less, and you provide significant personal services. This is akin to a bed and breakfast or a hunting lodge. These services are facts and circumstances based but usually include cleaning the rental property while occupied, concierge services, guest tours, transportation and other hotel-like services.

There are other exceptions, but those are the two most popular among rental property owners. If you cannot meet those exceptions, can you still deduct passive losses generated by rental activities? Maybe.

IRC Section 469(i) reads in part-

$25,000 offset for rental real estate activities
(1) In general
In the case of any natural person, subsection (a) shall not apply to that portion of the passive activity loss or the deduction equivalent (within the meaning of subsection (j)(5)) of the passive activity credit for any taxable year which is attributable to all rental real estate activities with respect to which such individual actively participated in such taxable year.

(2) Dollar limitation
The aggregate amount to which paragraph (1) applies for any taxable year shall not exceed $25,000.

Therefore, the tax code allows for up to $25,000 in passive losses generated from rental real estate activities to be deducted from nonpassive income (wages, investment income, business income, etc.). Yay! However, there are limits. Boo! Specifically, the $25,000 passive loss deduction exception reduces $1 for every $2 over $100,000 modified adjusted gross income (MAGI) and by $150,000 the passive loss deduction is $0. Bummer.

For example, you make $120,000 at your regular job and have $30,000 in rental losses. Your passive loss deduction is $15,000 ($25,000 minus $10,000) and the remaining $15,000 is carried forward.

Not all is lost, however. If your rental property losses are capped or unallowed because of passive loss limits, the portion exceeding the passive loss limit is carried forward on Form 8582, aggregated for each year, and may be utilized when-

• You sell (dispose) the rental property,

• You sell other rental properties that result in a gain, or

• You eventually have rental income (profits) that would otherwise be taxable.

Spoiler Alert: If you qualify for REPS on your rental properties or a rental property suddenly qualifies for the short-term rental loophole, the prior losses carried over on Form 8582 remain stuck unless you sell or have net rental income (profit). You cannot waive the magic REPS wand and make yesterday’s problems go away.

The $25,000 special allowance is the same for single filers and married couples filing jointly. However, for married persons filing separately (MFS) who live apart for the entire tax year, this limit is reduced to $12,500. If you live with your spouse for any part of the year and file MFS, the passive loss limit is $0 for each of you. Not good.

What the heck is modified adjusted gross income (MAGI)? To calculate your modified adjusted gross income, take your AGI and add-back certain deductions. Many of these deductions can be rare, so it’s possible your adjusted gross income (AGI) and MAGI can be identical. Different credit and deductions can have differing add-backs for your MAGI calculation. According to the IRS’s obscure Coke formula including MAGI calculations, your MAGI is your AGI with these items possibly added back-

• Student loan interest

• One-half of self-employment tax

• Qualified tuition expenses

• Tuition and fees deduction

• Passive loss or passive income

• IRA contributions

• Non-taxable social security payments

• The exclusion for income from U.S. savings bonds

• Foreign earned income exclusion

• Foreign housing exclusion or deduction

• The exclusion under IRC Section 137 for adoption expenses

• Rental losses

• Any overall loss from a publicly traded partnership

The big takeaways are- these are potential add-backs depending on your unique circumstances. Rental losses are always added back which makes sense otherwise the passive loss limits would have a circular reference. Foreign earned income exclusions calculated on Form 2555 are also added back. Student loan interest is as well, but this doesn’t usually push the needle around too much.

To summarize-

• Passive activity losses can only be offset by passive activity income. Generally, material participation changes the color of money, and the activity is no longer passive (see definition above).

• However, rental activities remain passive even if you materially participate. You must materially participate as a real estate professional. There is an exception, a loophole if you will, for short-term rentals where your average guest stay is 7 days or less and you materially participate. It is a loophole since you do not need to materially participate as a real estate professional in your short-term rental. Yes, convoluted, and we demystify the short-term rental loophole in a later section.

• If you cannot leverage real estate professional status or the short-term rental loophole, there is an exception allowing $25,000 of passive losses created by rental losses to be deducted against other nonpassive income. But you must actively participate.

• Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.
• Treasury Regulations Section 1.469-2 states that self-rentals, where you rent an office building to your business (as an example) is not considered a passive activity.

By Jason Watson, CPA
Posted Saturday, March 21, 2026

It is easy and common to overlook rental property and real estate investment nuances at the state level. Here are some random yet key considerations-

Required to File Tax Returns with Tax Loss

Although your rental property has a tax loss, you are usually required to file a state tax return. Why?

• Starting the audit and statute of limitations clock.
• Controlling the tax narrative.
• Tracking state versus federal depreciation differences including passive losses.
• Protecting your state basis for a future sale (which is often higher than federal).
• Reducing state challenges on gain calculations, especially when title companies withhold taxes from sale proceeds.

We dig into each of these in our filing state tax returns with your rental property section.

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 generally balance a budget (California notwithstanding).

When states do not follow the IRS, it is called state conformity or in some instances, decoupling. Many states decouple from federal rules in varying ways. Bloomberg Tax has a lovely list of state conformity to federal bonus depreciation.

This is another reason to prepare and file state tax returns for your rental property although it might have a federal tax loss. In other words, you could very easily have a tax loss on your Form 1040 individual tax return but have taxable income on your state tax return. Don’t shoot the messenger.

Taxable Rental Property Profits and State Credits

There are three sneaky situations here. We say sneaky since rental property owners get used to tax losses, and boom, one day they have a tax profit. Here are the situations

• You have a rental property in a tax-free state such as Washington, yet you live in a taxed state such as Ohio, or
• You live in Ohio and your rental property is in California (or any two states that have an income tax, especially ones that are disparate), or
• Conversely, you have a rental property in taxed state like California, but you live in Washington.

First things first- live in Ohio, rental in Washington. How this situation generally goes is like this- Ohio will tax you on your global income including the rental property profits in Washington. From there, it will give you a tax credit for taxes paid to other states for taxable income earned in other states. In our example, Washington does not have an income tax, so your rental property profits in Washington are purely taxed by Ohio. Yes, the income is earned in a tax-free state. We got it, but your resident state is going to take a bit of the apple.

Next, our second example- let’s say you live in Ohio, and the rental property is in lovely San Diego, California banging out a nice profit. You might pay taxes in California as a non-resident earning taxable income in their jurisdiction (yeah, dorky accounting geek-speak), and Ohio will also tax you. For now, you are being taxed twice on the same dollar. However, Ohio will give you a credit up to what Ohio would have taxed you for the taxes paid to California.

This credit might be less than the taxes paid to California since it is based on Ohio’s rate. Yuck, right? Wait! We say “might” twice for a reason- keep reading.

Let’s move along to the third example which is quite simple now knowing what you know. You have a rental property in a taxed state like California, but you live in Washington which is a tax-free state. California will tax the rental property profits earned there, and you will likely file a non-resident tax return should you exceed the filing requirements (or if you want your property management withholdings refunded- see below).

For the 2025 tax year, the non-resident filing threshold for California’s Form 540NR is $45,887 for married filing jointly (assuming both are under 65 with no dependents). However, California also uses an adjusted gross income test, meaning you must file if you exceed either threshold. These thresholds are based on income before most deductions, so you could have a federal tax loss on your rental property and still be required to file a California return. As such, you might duck under the filing requirement, but then again, what rents for less than $3,800 a month in California? (Yes, a lot of properties do, but don’t let the facts get in the way of a good ribbing).

To wrap this little state income tax wrinkle up with a bow, be aware of your tax footprint or as one of our clients says, “his taxable surface,” when it comes to your resident state and the other state that holds your rental property. Also, keep in mind that a lot of states don’t recognize accelerated depreciation (as we just discussed)- that makes all this multi-state rental property stuff a bit more interesting.

State Capital Gains on Your Rental Property

The federal tax code has a separate graduated tax system for long-term capital gains, and it is either 0%, 15% or 20% plus the possible net investment income tax of 3.8%. We call this a preferential tax rate.

For the 2026 tax year, a married couple pays 0% on long-term capital gains if their taxable income is $98,900 or less. The rate is 15% if income is between $98,900 and $613,700. It’s 20% if income is over $613,700. Single taxpayers are very similar ($49,450 and $545,500).

This sounds wonderful. However, most states do not have a preferential tax rate for long-term capital gains.

According to the Tax Foundation and as of the 2025 tax year, Minnesota and Washington have unique capital gains tax structures that can result in higher effective tax rates than ordinary income in certain situations. Arkansas, Arizona, Montana, New Mexico, North Dakota, South Carolina, and the class favorite, Wisconsin, enjoy a long-term capital gains tax that is lower than their ordinary income tax rate.

So when you sell your rental property and enjoy a cushy federal tax rate, you might pay California’s top rate of 13.3% or New York’s 10.9%. Minnesota is up there too with 9.85% and their capital gains tax rate is 10.85%. Oh, and it’s cold too.

Tax planning is a must.

1031 Like-Kind Exchanges Across State Lines

As just mentioned, every state is unique in terms of conforming to federal tax code but it doesn’t stop at depreciation. Let’s pick on California since it is an easy target. According to California’s instructions, in part, for 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 Form FTB 3840 every year until the deferred gain or loss is recognized. You sell in 2025 and complete a valid 1031 exchange into Texas (for example) and have zero remaining footprint in California. You feel good. However, you will file FTB 3840 in 2025, 2026, 2027, etc. When you finally sell that Texas property a decade later, California reaches across state lines to claw back the tax on that original 2024 deferred gain. Yay (not)!

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.

Non-Resident Withholdings By Property Managers

Who wants to pick on California some more? Excellent. If you own a rental property in California and you are not a California resident, your property manager is legally obligated to perform what is commonly referred to as nonresident withholding. Here is a blurb from their website–

California law requires withholding of tax by persons having the control, receipt, custody, disposal, or payment of items of income, commonly termed “withhold at source.” (Title 18 California Code of Regulations (CCR) section 18662-1(a)(1)). As a property manager providing services to nonresident property owners, including but not limited to renting, leasing, or collecting rent or lease payments on behalf of the nonresident owner, you are considered the withholding agent for California withholding purposes. As a withholding agent, you are required to withhold 7% on rent or lease payments to nonresidents when the total payments of California source income, excluding property management fees, exceed $1,500 for the calendar year.

Are there exceptions? Yes! Their website continues with-

For California withholding purposes, the following property owners are exempt from withholding:

1. California residents.

2. Corporations, Partnerships and LLCs registered with the California Secretary of State to do business in California, or who have a permanent place of business in California.

3. Estates where the deceased was a California resident at the time of death.

4. Nonresident owners whose gross payments do not exceed $1,500 in a calendar year.

Let’s say you lived in California, but you now reside in Texas leaving your home behind as an instant rental property. Your property manager is required to withhold 7% of your gross rent. This totally stinks if you have a tax loss since you now must file a California non-resident tax return just to get your tax refunded. California hopes you don’t, of course.

Could you create a California LLC that owns your rental property to sidestep this requirement? Yes. However, you will be required to pay the annual Franchise Tax which is a minimum of $800 (for the 2026 tax year). We expand on the LLC fee next.

Doing Business in California

This section should be called California state return matters. We use California for a couple of reasons- first, they have aggressive tax law and second, a lot of states call it progressive tax law and adopt many of California’s initiatives.

Could you be considered doing business in California with your non-California rental property? Yes! Here is a blurb directly and very much self-servingly from California’s Franchise Tax Board 3556 LLC MEO–

Paul is a California resident and a member of a Nevada LLC. The Nevada LLC owns property in Nevada. The LLC hires a Nevada management company to collect rents and provide maintenance. Paul has the right to hire and fire the management company. He occasionally has telephone discussions from California with the management company in Nevada regarding the property. He is ultimately responsible for the property and oversees the management company. Paul conducts business in California on behalf of the LLC. The LLC must file Form 568.

It’s almost like they know you, right? Form 568 is California’s Limited Liability Company Return of Income where they assess your LLC’s tax obligation. Read the example about Paul above again. Although his LLC is in Nevada, he will have to file Form 568 as if his entity was registered in California.

California LLCs, including SMLLCs and MMLLCs, are subject to an LLC fee based on gross receipts. On gross receipts! If your rental makes a $1,000,000 and incurs $950,000 in expenses, you still pay a franchise tax, called an LLC fee, computed on the $1,000,000.

The fee is “banded” as we say since it is not a straight calculation based on a percentage.

Gross Receipts	LLC Fee
250,000 to 499,999	900
500,000 to 999,999	2,500
1,000,000 to 4,999,999	6,000
5,000,000 +	11,790

Keep in mind the minimum Franchise Tax of $800 regardless of gross receipts. Is there an exception for rental property income? Nope! According to California’s website describing their shameless revenue generation-

LLCs are subject to an annual fee based on their total income “from all sources derived from or attributable to California” (R&TC Section 17942). Total income for LLC fee purposes is “gross income, as defined in R&TC Section 24271, plus the cost of goods sold, paid, or incurred in connection with the trade or business of the taxpayer.”

Yuck.

California Real Estate Professional Status Non-Conformity

Who wants to pick on California some more? We all do. California Revenue and Taxation Code Section 17561(a) reads-

(a) Section 469(c)(7) of the Internal Revenue Code, relating to special rules for taxpayers in real property business, shall not apply.

Ok, neat. What does IRC Section 469(c)(7) read (you can probably guess)-

(7) Special rules for taxpayers in real property business

(A) In general
If this paragraph applies to any taxpayer for a taxable year—

(i) paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year

This is slightly out of context so your guess might have been off, but you’re likely heading down the right rabbit hole. This verbiage of the federal tax code is from the passive activity losses and credits section which basically limits rental property losses. Paragraph (c) in particular defines passive activity. As such, subparagraph (c) reads that real estate professionals have special rules and this section of the tax code does not apply. Cool, provided your rental income is not derived in California.

California in turn legislates that IRC Section 469(c)(7) does not apply to their code regarding passive activities. Each state is different, and California is one that is clear and obvious with their code.

Other states are not as obvious, and as of this writing, we cannot determine if there are any.

By Jason Watson, CPA
Posted Sunday, October 5, 2025

Coming off the previous rental property tax strategy section where we focused on a handful of real estate tax strategies, the following are smart moves and related considerations real estate investors use to get the most out of their rental properties, tax deductions, and cash flow while minimizing risk. Man, that was a long sentence.

Each tip, trick or hack has just a few words describing the move. We are following the mini skirt rule- short enough to keep it interesting, but long enough to cover the topic. Most of these are expanded in various sections of our book. Also, all of these are 100% legal when done right- you just document to properly defend, and you cannot be unreasonable. Sounds easy, right? If your tax professional says Nope, then perhaps you need to find the right real estate CPA to guide you.

Multi-Member LLC Cloak

Worried about audit exposure and risk with your short-term rental property and the big tax deduction from cost segregation paired up with bonus depreciation? A multi-member limited liability company can provide some distance and some invisibility. Form 8825 in conjunction with a partnership tax return (Form 1065) enjoys a much lower audit rate than an individual tax return (Form 1040). Your rental property loss is just a bit less in the IRS’s face.

See Benefits of Rental Property In Partnership Entities section for more information.

Wyoming LLC Holding Company Tip

Want even more anonymity along with wealth transfer? Have your rental property owned by an LLC, and have that LLC owned by a Wyoming LLC that is a real estate holding company. In turn, the holding company is owned by you and your spouse, files a partnership tax return (unless you reside in a community property state) and the Operating Agreement dictates transfer of member interests upon death to act like a mini trust. Yet, another long sentence.

See Multi-Entity Rental Property Tiered Structure section for more information.

Property Management Company Hack

Create an LLC to manage your own rentals using a customary and usual fee arrangement. From there, you flip passive income into earned income (change the color of money if you will) and you can then fund a solo 401k plan for you and your spouse, plus put kids on payroll. This can also create more legitimacy for your real estate professional status hours. Some states require special licensure or handling for property management companies.

Home Office Travel Trick

A real home office turns “commuting” into “deductible business travel.” Keep in mind that your rental properties are businesses if you continuously and regularly work them with a profit motive. Back to the home office- driving from your home to check on your rental across town is typically considered commuting and therefore not deductible. Yuck! Conversely, a home office makes your commute from the bedroom to the basement, and miles from there are business miles. You need a dedicated space that you use regularly and exclusively for the rental property activities. Travel outside your tax home usually is deductible without a home office.

See Rental Property Travel Deductions section for more information.

Buying A Car For Your Rental Property

Buying an automobile for your rental properties isn’t automatically deductible. It must be both ordinary (common in your business) and necessary (actually useful). However, once you clear those hurdles, it becomes a nice tax deduction. Passenger automobiles are listed property, so you’ll need mileage logs if you mix business with pleasure, or sufficient evidence if you claim the automobile is 100% for the rental business. Heavy vehicles (over 6,000 pounds) remain eligible for IRC Section 179 expensing plus 100% bonus depreciation. Therefore, a $100,000 truck is fully deducted in year 1 and if you can sidestep the passive activity loss limitations, then this is a direct tax deduction to you.

See Buying A Car For The Rental Property section for more information.

Put Kids On Payroll (for real)

Pay your kids for legitimate work such as cleaning, data entry, mowing the lawn or managing listings. To give your kid $10,000 you might have to earn $15,000 given your income taxes. Conversely, with payroll processing (yes, real W-2 and everything), you deduct $10,000 in wage expense at a high tax rate and your kid pays $0 in taxes, plus they can fund their Roth IRA and save for college. They can still be your dependent too. This either lowers your taxable rental property income or extends your rental losses that you deduct (provided you get around the passive activity loss rules with short-term rental loophole or real estate professional status).

See Paying Your Children From The Rental section for more information.

Your Business Rents Your STR Tip

Your business can rent your short-term rental for real meetings and retreats when you document it properly. Fair market rent, agendas, attendees, and photos are helpful when defending the “trust me, we talked about KPIs in the hot tub.” You can safely take net business profit, from an S Corp for example, and use it to offset rental property losses. This rental property hack is incredible if you are unable to deduct rental losses otherwise. As an aside, this is a slight twist on the August Rule.

See My Business Rents My Short-Term Rental section for more information.

Your Business Rents Your LTR

Similarly to your business renting your short-term rental from time to time, your business could also rent your long-term rental as a second office location. You have a lovely condo in San Diego, and you are drumming up business in Southern California, why not have your business rent the condo from you? Sure, there are rules and risk, but they are manageable from a smart real estate CPA.

Retro Cost Seg Time Machine

File Form 3115 with an IRC Section 481(a) adjustment and run a look-back cost segregation study to scoop up old depreciation and drop it into the current year. This is especially handy if you’ve hit the short-term rental loophole eligibility or real estate professional status this year, yet you won’t in future years. Also, this a great tax planning trick when you have an artificially or unusually high income from other sources such as W-2 or capital gains. This is like a nice food pairing such as grilled cheese and tomato soup in the dead of winter.

See Retroactive Look-Back Cost Segregation Study section for more information.

The Spouse Hours Trick

When you and your spouse work on the rental property together, those hours are combined when filing a joint tax return to meet material participation hours. Romantic dinner? Nope, but if you have a separate property management LLC, then Yes the business can pay for a business meeting over dinner and Yes your hours count if you spend time reviewing vendor contracts or local compliance rules. Keep in mind that spousal hours do not count towards the 750 hours needed for real estate professional status.

Short-Term Rental Now, Long-Term Rental Later

Run your property as a short-term rental for a year, grab 100% bonus depreciation, then pivot to a long-term rental or personal use. It’s like getting a tax deduction dessert ahead of the consistent rental property income and low headache green beans and vegetables. While that analogy might need some work, it remains a sound rental property hack. There is some risk that needs to be sorted with help of a rental property expert team.

Last Year Spending Splurge Rental Hack

Right before you wake up and decide that a short-term rental is no longer your idea of a good time, renovate the kitchen to claim a Qualified Improvement Property tax deduction and buy all new furniture in the style and taste that someone just like you would want. Consider the option of selling the money pit, but then come to your senses and say, “hey, this could be a nice second home.” Yup! You guessed it. Most risk that needs to be sorted.

See Arbitrage Of Converting STR To Second Home section for more information.

Group Related Activities Rental Tip

Grouping similar activities together helps with material participation thresholds. Short-term rentals together. Long-term rentals together. Group your business with the office condo that you own personally to offset business income with self-rental losses (if you don’t group, your self-rental losses are passive and therefore limited). This is done under Treasury Regulations Section 1.469-4 which is the general grouping election versus 1.469-9g which is the one reserved for real estate professionals.

Group Your Late Year STR Purchase

Bought a new short-term rental deep into the year? Worried about hitting 100 hours with no one else doing more than you? Can’t really swing the substantially all hours threshold without renting a hotel next to your short-term rental property? Group the shiny new STR with your other STR(s) so your hours stack up for material participation. Would this be a hacky stack? Oh, don’t roll your eyes.

Jet Ski With A Schedule E

Lease recreational gear (kayaks, golf cart, bikes) to guests as part of the rental property. You can purchase equipment, depreciate it, and use those losses to offset rental income and reduce your rental property income taxes. When you visit your STR, you have something fun to play with as well (just keep personal use in check). Group the activity (the equipment and the rental) together to help with material participation for both activities.

See Renting Recreational Equipment Alongside Your Rental Property for more information.

Maintenance Days Don’t Count Against You

Under IRC Section 280A, workdays don’t count as personal use provided that substantially most of the day was spent on repairs. Tack on some personal use days yet keep the primary purpose of the trip as repairs, and travel might be deductible as well. A nice little combo platter. Be cautious- spending 32 hours changing the toilet is unreasonable and tax courts are filled with humans who understand the game (and the player).

Slice And Dice Bonus Depreciation Tip

Property with 20 years of useful life or less is generally eligible for bonus depreciation. However, with smart tax planning by rental property CPA, you might want to opt out of 5-year property, and let 7-year and 15-year property be fully deducted. This allows for some nice depreciation in the future as well as a big chunk today. This hedges your bet between today and tomorrow.

Place In Service Day 1, Renovate Day 2

Placing your rental property into service where it is ready and available for rent (and you can support it), starts two critical clocks- a) material participation time and b) operating expenses such as insurance, utilities and HOA dues are deductible. It also opens the door to Qualified Improvement Property (QIP) where you may be able to fully deduct a $100,000 kitchen renovation in the first year should you have a short-term rental. If you buy on a Monday and renovate on a Tuesday, then you are stuck with normal depreciation. Yuck.

See Rental Property In Service Defined for more information.

Closing Thoughts

Rental properties remain a wealth-building tool first and foremost. Can we weave some tax efficiency into the mix? Yes. Can we add some personal pleasure to all this? Yes.

By Jason Watson, CPA
Posted Sunday, October 5, 2025

We often get asked about rental properties, specifically short-term rental properties, and how they are a part of an overall tax strategy especially among high income earners. As we’ve mentioned elsewhere, rental properties are a wealth building strategy not solely a tax reduction strategy. However, they can be both! More like a train of wealth building cars with a tax strategy caboose. Let’s not forget lifestyle which is truly the caboose in our wealth building and tax strategy train.

A lot of this material is scattered in our book, so we will make references to certain sections for expanded reading. What we are doing here is providing a checklist of sorts to run through as you incorporate rental properties into your tax strategy.

Passive Activity Loss Limitations

The phrase “tax strategy” is code for paying less in taxes. Simply buying a rental property does not reduce your taxes if you are passive loss limited. Specifically, if your modified adjusted gross income (MAGI) exceeds $150,000 then your passive losses from rental activities or any other investment activity is limited, and carried forward into the future on Form 8582. Recall that rental property activities are inherently deemed passive unless you meet some criteria (that we discuss in a bit). Also, MAGI for this purpose is generally adjusted gross income (AGI) before passive loss limitations (and in contrast is not the same MAGI when considering IRA income limits).

Sidebar: According to a 2022 census, about 12 million households had MAGI above $150,000, the phaseout threshold, representing about 8-9% of all U.S. households.

You need three things, and not necessarily combined, for rental properties to avoid being negatively impacted by passive activity loss limitations and therefore become lovely tax vehicles-

• Be designated a Real Estate Professional or REPS for short. This is 750 hours in real estate activities per year, over 50% of your time spent on all activities including W-2 jobs is spent in real estate, and you materially participate in a rental activity. Hours spent on short-term rentals do not count towards the 750 hours since they are deemed trades or businesses like a hotel, and not a rental activity. Read our real estate professional status section.
• Qualify for the short-term rental loophole. This is where you have a rental property that is rented for an average of 7 days or less per stay and you materially participate in the rental activity. The three material participation tests for most rental property owners are 500 hours, 100 hours and no one had more hours than you, or substantially all hours (used often near the end of the year). Read our short-term rental loophole section and material participation rules section.
• Have other taxable passive income from real estate syndicates or existing rental properties.

Your tax strategy must start with getting around passive activity loss limitations otherwise your rental property is just a wealth-building or lifestyle strategy.

Cost Segregation Study Tax Strategy

If you can bypass the passive activity loss (PAL) limitations through real estate professional status or short-term rental loophole, then a cost segregation study might be in order. Cost segregation is a process that identifies personal property and parses it away from real property (the building), and in turn allows for accelerated depreciation or IRC Section 179 expensing. On a $600,000 purchase where $400,000 is allocated to the building, you could see a $70,000 to $90,000 tax deduction just from a cost segregation study (about 18 to 25% of the building’s cost depending on the size and design). At a 32% marginal tax rate, a cost segregation study becomes part of your tax strategy with a savings of $25,000 in cash using our example.

Keep in mind that cost segregation is purely a cash flow play. There isn’t any magical depreciation or a secret tax deduction that is created- what is available to you over time is suddenly compressed and available to you today with a cost segregation study. Also, keep in mind that depreciation is a unique tax deduction since it is a cashless expense- sure, you are using your own cash in a roundabout way either through a loan that must be repaid or your own cash in a loan-free purchase. However, it just feels different, right?

Bonus Depreciation Tax Strategy

With the One Big Beautiful Bill Act signed into law on July 4, 2025, bonus depreciation is back to 100% for a bunch of years. Yay! Bonus depreciation is available on any asset that has a useful life of 20 years or less. This allows for personal property identified in a cost seg, appliances, land improvements, hot tubs and even a kitchen renovation (we’ll talk about qualified improvement property in a bit) to be immediately and fully depreciated and therefore tax deductible in the first year.

What is also sexy about bonus depreciation is that it does not have a claw back provision like IRC Section 179. Huh? If an asset, such as a rental property, falls to 50% or less business use, any Section 179 benefit is recaptured as ordinary income and becomes taxable to you. Yuck. However, bonus depreciation does not have this poison pill. The one knock on bonus depreciation is that many states do not recognize it- as such, you get a big federal tax deduction, but your state says No and forces you to use typical depreciation.

Should you sell your rental property outright (versus using a 1031 like-kind exchange), all depreciation and Section 179 benefits are recaptured regardless. Read our accelerated depreciation and Section 179 deduction section.

Qualified Improvement Property Tax Strategy

Qualified Improvement Property (QIP) is defined as any improvement made to the interior of a nonresidential building after the building is placed in service and is eligible for bonus depreciation. Improvements exclude expansion of the building and changes made to a building’s internal structural framework. Oh, and let’s not forget that residential property also does not qualify- what does that mean? Any rental where the average guest stay is 30 days or less is considered nonresidential (in slight contrast to the tighter requirement of 7 days or less for the short-term rental loophole).

How is this a tax strategy? In a typical long-term rental property, any improvement such as a kitchen renovation is capitalized and depreciated over time. However, with a short-term rental property or technically a nonresidential property, a $80,000 kitchen reno becomes an immediate tax deduction with bonus depreciation under IRC Section 168(k). If you later convert the rental property into a second home in the future, this improvement checks both lifestyle and tax reduction boxes.

Home Office Tax Strategy

This can be a rabbit hole so we’ll keep this brief. Deducting a home office in connection with your rental properties has challenging requirements. Under IRC Section 280A, your space must be dedicated, and regularly and exclusively used for your rental property activities. What is regular and continuous? It is not defined anywhere, however, a single long-term rental property is unlikely to support regular and continuous. A single short-term rental property? Perhaps. A rental in Florida is a bit different than a ski condo since one is rented 40 weeks of the year and the other might get 15 weeks if you are lucky.

The big play on home office deduction as part of your rental property tax strategy is travel expenses. Most travel to a rental property in the same geographic location as your primary residence (tax home) will be considered commuting and therefore not tax deductible. Add a home office, and suddenly your commute is from the bedroom to the basement, and travel from your home to the rental property across town is deductible travel. We expand on this in our home office deduction section.

If you have a home office for your non-rental business, then combining it with your rental property activities might be counterproductive. In a non- S corporation environment, a home office deducted on Schedule C against your business or independent contractor income or against your partnership K-1 income, reduces both income taxes and self-employment taxes. This is preferred over reducing your rental property income or using rental losses to offset W-2 income since that tax strategy only reduces income taxes and not both income taxes and self-employment taxes.

Rental Property Automobile Tax Strategy

This is similar to the home office tax strategy, but with another layer of risk. Any business tax deduction including a rental property tax deduction requires that the expenditure is ordinary and necessary under IRC Section 162. Deducting mileage on your personal automobile for travel to the rental is a snap. Rather, let’s talk about a Lamborghini Urus purchased by the rental property. Roll with this for a minute. Ordinary means that everyone in the rental property business owns an automobile dedicated or mostly dedicated to their rental activities. Technically, ordinary means everyone in your line of work, business or industry has the same expenditures which might include automobiles.

Necessary means that your rental business would suffer financially if you did not have a Lambo to rock up to your short-term rental with a fresh basket of towels. The U.S. Supreme Court in Welch v. Helvering, 290 U.S. 111 (1933) states that necessary means appropriate and helpful. A Lamborghini Urus is a sexy automobile. Incredibly sexy. However, most reasonable people would consider a Lamborghini beyond appropriate and helpful, and would likely recommend a nicely used Porsche Macan for your towel delivery service.

In other words, to be deductible under IRC Section 162, an expense must be ordinary (common and accepted in the rental property industry) and necessary (appropriate and helpful to your rental activity), and when combined, the amount must be reasonable under the circumstances.

How can you make this work? Two options might exist. First, you have several rental properties, and it just makes sense to have a dedicated van or work truck to bounce between them all including Home Depot or Lowe’s. That’s easy and not very attractive to most people wanting to reduce their taxes since this option is more operational and born out of necessity.

The second option involves a bunch of risk. You could own a $100,000 SUV personally and lease it back to your rental property or series of rental properties. For example, you use the automobile 60% of the time for your short-term rental property. You would lease it to your rental property at fair market value (for example, $300 a week or about $15,000 a year). Your rental property would have a $15,000 lease deduction. You would pick up $15,000 in nonpassive income on Schedule 1.

Sidebar: You would not report this on Schedule E since it is personal property and not leased alongside real estate. You would also not report this on Schedule C since you are not in the car rental trade or business.

You would also report depreciation at 60% and other expenses at 60% on Schedule 1 to offset this income. In other words, your tax strategy is to increase losses in your rental property, and have it be a net-zero on the other side.

Sidebar: We slipped in the word “nonpassive” when referencing the lease income. This is an important detail since you cannot use nonpassive income (profits) to offset passive losses (such as those from long-term rentals).

Keep in mind that the IRS absolutely despises self-rentals or related party transactions with the heat of a thousand suns. You would need to document the business purpose and need, and ensure the transaction is at fair market value to support the arm’s length hurdle. Also, keep in mind that IRC Section 179 prohibits expensing in this situation, and IRC Section 168(k), where accelerated depreciation lives, also has anti-abuse provisions as reinforced by Treasury Regulations Section 1.168(k)-2.

In practice, you can split the baby between boring basic mileage deduction and sleek Lamborghinis with a well-documented SUV lease between you, personally, and your rental property activity.

Rental Property Maintenance Tax Strategy

Recall that under IRC Section 280A you can personally use a rental property for 14 days or 10% of its fair rented days, whichever is higher, without falling into the friend zone. Ok, not the friend zone like Chris Rock talks about, but rather vacation home rules where your losses are suddenly limited to rental revenue.

However, if you perform routine repairs and maintenance to the rental property for substantially most of the day, then that day doesn’t count against your personal use allotment. For example, you visit your short-term rental property for 4 days. 3 days were spent painting, fixing that railing, swapping out door locks with ones that actually work, staining the deck (again), and shopping for new throw pillows since the current ones are nasty. In this example, only 1 day is considered a personal use day.

No, you can’t wake up at 9:00AM, hose the patio off at 9:15AM while sipping a coffee, check the ball bearings on the garage door opener for wear at 9:50AM, and then call it a day at 9:53AM after realizing that openers don’t have ball bearings. See our vacation home rules section for more information.

Second Home Tax Strategy

You could easily take all this to a new level. Is the following a WCG CPAs & Advisors recommendation? Um, No. It is a smash up of observations blended with a dash of tax code. Here we go on a very extreme and compressed timeline-

The first year, you place the short-term rental property into service on day 1.

• On day 1, you purchase a bunch of really nice furniture and other supplies.
• On days 2-29, you rent it out twice for 7 days or less to friends you trust, and you substantially do all the hours of cleaning and maintenance.
• On day 30, you complete a cost segregation study and start a major non-structural interior renovation. Yes, the rental property is no longer available to rent but remains in-service since you intend to rent it again.
• At tax time, you bonus depreciate property identified in your cost segregation study plus your nonresidential renovations as qualified improvement property (QIP). Your furnishings are fully expensed provided each item is under $2,500 (alternatively, the purchases are capitalized and depreciated with bonus depreciation). Your high W-2 income is reduced by the losses from your short-term rental.
• Starting with the second year, you attempt to rent it as a short-term rental like you did before, but the market is soft and your place is totally amazing with the reno and fancy furniture, and you just aren’t getting any good guest reservations.
• You take the rental out of service, and make it your second home.

Of course, this is rather nutty and is an extreme example of short-term rental loophole as a tax strategy and a lifestyle improvement. The risk is high that the IRS would challenge the legitimate business purpose at every turn. In other words, is this a thinly veiled way of creating a large tax deduction through a short-term rental converted to second home tax strategy?

Who wants a less extreme version of similar facts?

• Start off with a short-term rental with the cost segregation study and major non-structural renovation (qualified improvement property) as above.
• 15 years later, buy a bunch of nice furniture and spritz up the place with new paint, flooring and other odds and ends in between guest stays.
• Paint your last wall, buy your last sectional, and welcome your last short-term rental guest on your way to taking the rental property out of service in favor of being your second home.

Rental Property Tax Strategy Summary

We say everywhere, and we’ll say it again- rental properties are a part of your long-term wealth-building strategy first and foremost. Secondarily, rental properties can be a short-term tax strategy with emphasis on the word “can.” The most impactful tax strategy is either real estate professional status or short-term rental loophole combined with a cost segregation study and bonus depreciation. The home office and automobile tax strategies are a distant second.

Finally, we discussed the rental property maintenance tax strategy which is more of a lifestyle strategy. However, if your lifestyle can be supported alongside a reduction in taxes, then that is a double win.

By Jason Watson, CPA
Posted Sunday, August 31, 2025

Let’s back up a bit. Our book loves to spill the beans so-to-speak with the net-net fun facts, and then dig a hole under the house for the foundation. Wow. All kinds of metaphors. There are three types of income- earned, portfolio and passive.

Earned Income

Earned income is income that is a direct result of your labor. This income is usually in the form of W-2 wages or as small business income reported on Schedule C of your individual tax return (Form 1040). Both are subject to Social Security and Medicare taxes (self-employment taxes). There are other areas such as Schedule E or F where income can come into your individual tax return and be subject to self-employment taxes, but Schedule C is the most common.

Portfolio Income

Portfolio income is income generated from selling an asset, and if you sell that asset for a higher price than what you paid for it originally, you will have a gain. Depending on the holding period of the asset, and other factors, that gain might be taxed at ordinary income tax rates or capital gains tax rates. Interest and dividends are other examples of portfolio income.

Capital gains are not a form of income per se. Capital gains simply defines how your portfolio income will be taxed. Income is income, and is therefore taxed. This income might be taxed at capital gains rates or ordinary rates. Subtle difference.

Portfolio income is not subjected to self-employment taxes, but it might be subjected to net investment income tax (NIIT). See our section on real estate professional status (REPS) which side-steps NIIT.

Passive Income

We touched on this in a previous section. Passive income bluntly is income that would continue to generate if you died. Morbid. How about this? Passive income is income that would continue to generate if you decided to do nothing and sunbathe on some beach. That sounds better. Passive income includes rental property income and royalties, and income from businesses or investment partnerships / multi-member LLCs where you do not materially participate.

Passive income is also not subject to self-employment taxes but similar to portfolio income, it might be subject to the Net Investment Income Tax (NIIT). So, if you own a rental property, the net income (profit) generated from the activity is considered passive income although your participation might be considered active. If you take this same rental activity and provide certain services such as tours, your income might be considered earned income and subject to self-employment taxes.

Additionally, if you wrote a book and receive royalty checks, that income is also passive and not subjected to self-employment taxes. However, if you write several books or make updates to an existing book (like this one) then you are materially participating in your activity and your income is earned income. And Yes, you would pay self-employment taxes on that income.

You might also intentionally want passive income to offset or absorb your passive losses. We talk about passive income generators (PIGs) in a later section. No, you cannot manufacture passive income to allow passive losses to be deducted with self-rentals.

Self-Rentals

It is common for a business owner who relies on machinery or equipment, including real estate such as an office building, to have two business entities. One entity is an LLC that owns the assets. The other entity is an S corporation which leases the assets from the LLC for use in the business.

Treasury Regulations Section 1.469-2 boringly reads-

(f)(6) Property rented to a non-passive activity. An amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property-

(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of Section 1.469-5T) for the taxable year; and

(ii) Is not described in Section 1.469-2T(f)(5).

Read that first paragraph again. The phrase “treated as not from a passive activity” tends to stand out. This essentially means you cannot use a self-rental to generate a bunch of passive income to offset your otherwise non-deductible passive losses.

In turn this would suggest that you cannot benefit from a cost segregation study or rental losses in general since you would be limited by passive activity loss limits (more on that in a bit). However, under Treasury Regulations 1.469-4(c)(1), you can group the business activity with the self-rental activity to create an economic unit. This would allow you to offset income from the business operations with losses from the self-rental.

This makes sense right? If your business simply purchased a warehouse or office building directly, and leveraged a cost segregation study to accelerate depreciation for a quick and substantial tax deduction, it generally would not be limited. But if you owned the real estate in a separate entity and lease it back to your business, the self-rental suddenly becomes limited? The answer is No, but there are some rules.

Sidebar: What if your S Corp has a business purpose to rent your short-term rental? If your short-term rental qualifies for the loophole by having average guest stays of 7 days or less, and you materially participate in the rental activity, then the rental taxable income or loss is considered nonpassive. Self-rental income is considered nonpassive as well. This works. Check out our my business rents my short-term rental section for more information.

Either the activity is insubstantial when compared to the other activity or has the same proportionate ownership interest in the rental activity. The regulations also mention similarities and differences in types of business, the extent of common control and ownership, and geographical location. In the case of an owner-occupied warehouse or office building, these criteria are usually met. Moreover, the Section 199A qualified business income deduction would normally not be allowed with a self-rental, but when aggregated under Treasury Regulations 1.469-4(c)(1), it remains applicable.

Keep in mind that similarly to other grouping elections such as Treasury Regulations 1.469-9(g) which allows rental activities to be grouped as one for the purpose of real estate professional status (REPS), the grouping of your business and your self-rental must continue unless there is a material change in the facts and circumstances that renders the grouping inappropriate.

By Jason Watson, CPA
Posted Sunday, October 5, 2025

Here are some FAQs you might find helpful for our hodge-podge of tax rental property tax considerations-

What are passive activity loss (PAL) limits?
The IRS generally disallows losses from passive activities (like rentals) unless you have passive income to offset or qualify as a real estate professional.

Can I treat income from renting property to my own business as passive income?
No. Under Treasury Regulations Section 1.469-2(f)(6), income from a self-rental to a business in which you materially participate is treated as nonpassive. This means you cannot use that income to offset passive losses from other rental properties.

Can I use a cost segregation study on a self-rental property?
Only if you group the rental and business activity under Treasury Regulations Section 1.469-4(c)(1) to form an economic unit. When grouped, losses from the rental (including accelerated depreciation) can offset business income, assuming the business and rental meet common ownership, control, and activity requirements.

Does self-rental income qualify for the Section 199A QBI deduction?
Typically no—unless the self-rental is aggregated with the operating business under the same grouping rules above. If the rental and operating business share common ownership and meet other criteria, then the qualified business income (QBI) deduction may apply.

How much loss can I deduct if I don’t qualify as a real estate professional?
Up to $25,000, phased out if your modified AGI exceeds $100,000 and fully eliminated at $150,000.

What is the real estate professional (REPS) exception?
If you qualify under IRS rules, your rental activities are treated as nonpassive, allowing you to deduct all losses against other sources of income.

Can rental properties be an effective tax strategy?
Yes. Rental properties can combine wealth building with a tax strategy by generating income, creating depreciation deductions, and offering opportunities to offset high W-2 income through real estate professional status or short-term rental rules.

How do passive activity loss rules affect a rental property tax strategy?
This is where things go well or go sideways. If your modified adjusted gross income exceeds $150,000, rental losses are typically suspended under passive activity loss rules unless your tax strategy includes real estate professional status or the short-term rental loophole.

Why is a cost segregation study a key rental property tax strategy?
A cost segregation study identifies assets eligible for accelerated depreciation or Section 179 expensing, turning long-term depreciation into immediate tax benefits—an essential cash flow and tax strategy for high-income earners.

How does bonus depreciation enhance a rental property tax strategy?
Under IRC Section 168(k), bonus depreciation allows for an instant deduction of qualifying assets with a useful life of 20 years or less, making it a powerful tax strategy without the recapture risks of IRC Section 179.

What is the qualified improvement property tax strategy?
The QIP tax strategy lets short-term rental owners (or any property considered nonresidential with average guest stays of 30 days or less) to immediately deduct interior renovation costs under bonus depreciation, turning major improvements, such as a kitchen renovation, into instant tax deductions.

How does a home office support a rental property tax strategy?
A home office can shift local rental travel from non-deductible commuting to deductible business travel, making it a strategic tax move when managed correctly under IRC Section 280A. It won’t blow your hair back like cost segregation and bonus depreciation, but it counts for something.

What is the second home tax strategy for rentals?
The second home tax strategy uses short-term rental operations, cost segregation, and bonus depreciation before converting a rental property to personal use, blending lifestyle and tax advantages. Two for one- Does it carry a lot of IRS risk and scrutiny? Yes.

Does California recognize the REPS exception?
No. California does not conform to IRC Section 469(c)(7), meaning real estate professional status doesn’t apply for state tax purposes. Yuck.

Can I take accelerated depreciation in California?
Generally no. California disallows bonus depreciation and limits Section 179 deductions more than the federal code does.

How many states do not allow bonus depreciation (conform to the federal tax code)?
Lots. Around 20 or so.

Do states treat capital gains from rentals like the IRS does?
Not always. Many states don’t offer preferential rates for long-term capital gains from your rental property sale, taxing them at higher ordinary rates.

Am I required to file a state tax return if my rental has a loss?
Yes. Most states still require a return to be filed if you own income-producing assets in the state, even with a tax loss. There is also the non-conformity or decoupling from federal tax code issue as well.

If I live in a state with an income tax but own rental property in a tax-free state, do I owe state income tax?
Yes. Your resident state (e.g., Ohio and the other 40 states) taxes global income, including rental property profits earned in tax-free states like Washington. Since Washington does not have an income tax, no credit is given—your resident state taxes the income in full.

What happens if I live in Ohio and own a rental property in California?
You’ll owe California non-resident income tax on the rental property profit, and Ohio will also tax the same profit. However, Ohio provides a tax credit for taxes paid to other states—though only up to the amount Ohio would have taxed that income.

If I live in a no-income-tax state like Washington and own rental property in California, do I owe state taxes?
Yes. California will tax the rental property profits as California-sourced income, and you’ll likely need to file a non-resident return (Form 540NR). Washington won’t tax your income, but you are still on the hook in California. There are exceptions to filing, however.

How are vacation homes taxed differently?
If personal use exceeds certain thresholds, deductions are limited and must be prorated based on rental vs. personal use days.

What are the vacation home use thresholds?
14 days or 10% of the rental days, whichever is higher. Exceeding this day limit makes the property a “home,” limiting deductible expenses.

What’s the Tax Court Method for vacation homes?
It prorates mortgage interest and property taxes over the full year, often allowing more to be deducted on Schedule A. IRS was not thrilled.

Can I carry forward unused vacation home deductions?
Yes, but only to offset future rental income. They don’t carry forward like your PALs (passive activity losses) and don’t offset other income sources.

Are mortgage interest and taxes always deductible on a vacation rental?
Only the rental-use portion is deductible on Schedule E. The personal-use portion may be deductible on Schedule A, subject to limits.

When should I report rental income on Schedule C instead of Schedule E?
You should report rental income on Schedule C only if you provide substantial personal services to tenants similar to those provided by hotels, such as daily cleaning, meal service, concierge support, or valet parking. These services must go beyond what is typically offered in a standard rental.

Do short-term rentals automatically go on Schedule C if I materially participate?
No. Even if you materially participate or use the short-term rental loophole, the activity is still reported on Schedule E, not Schedule C, unless you provide substantial personal services as defined by IRS Publication 527.

What types of real estate income are usually reported on Schedule C?
Generally, only real estate brokers, property managers for other owners, or fix-and-flip operators report income on Schedule C. Regular rental activity, including STRs without hotel-like services, should remain on Schedule E or Form 8825 for partnerships.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

We refer to hotels and hotel-like services such as a hunting lodge or bed and breakfast, and we also mention self-employment taxes and whatnot. What does it all mean? While this topic is quite simple, and while this section will be quite short, we feel compelled to write separately about Schedule C versus Schedule E for your rental property activities.

The common misconception among real estate investors and tax professionals alike is that if you materially participate in the rental activity, including leveraging the short-term rental loophole or real estate professional status, you report this fun stuff on Schedule C.

Wrong. Sure, that is harsh. How about this? Not elegant. Feel the sting just disappear?

All rental properties including short-term rentals and commercial properties are reported on Schedule E and Form 8825 if filing as a partnership all day long, except if you provide substantial personal services.

Here is the exact verbiage from IRS Publication 527 Residential Rental Property-

If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, report your rental income and expenses on Schedule C.

Swell, let’s expand on this a bit or at least give you a laundry list (pun intended) of substantial services-

• Daily housekeeping service, turn down with chocolate optional
• Changing bed linens and towels during the stay
• Daily meal service or breakfast (think bed and breakfast) or room service beyond Door Dash
• 24/7 front desk or concierge services (think beyond laminated local dining guide in a 3 ring binder)
• Valet parking (bring a car with a stick shift, they love that)
• Recreational activities (hosted tours, event planning like weddings or corporate events)
• Transportation services such as airport shuttle
• Personal laundry services (obnoxious fees encouraged)
• Wake-up calls (does anyone really do this anymore?)
• Access to staffed gyms, spas, or pools including spa like services (massage, health and beauty)

As such, unless you provide a big chunk of this stuff, your rental activity, including your short-term rental, will be reported on Schedule E or Form 8825, but definitely not Schedule C.

The antithesis of substantial services include cleaning between guest stays (housekeeping), setting out some cheesy wine and K-cups (meal service), offering parking spaces (transportation), and supplying bikes and kayaks (recreation). They are similar to some of the items above, but they don’t rise to the same level and as such they are not the same as providing substantial services. The basic question is- are you acting like a hotel or like a nice weekend getaway that is mostly self-serve.

Sidebar: Once you provide substantial services, your activity is no longer considered a rental activity and therefore is reported on Schedule C as we’ve explained. However, it remains passive unless you materially participate. Yes, this is an oddity.

The only other real estate related activities we see reported on Schedule C among real estate investors is property management for other owners, real estate brokerage, and fix and flips. And if you make more than $50,000 in profits, you should strongly consider an S corporation election to save on self-employment taxes and avoid Schedule C all together.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Chapter 4 is a short chapter but how rental income is viewed by the IRS and when rental losses can (or can’t) be deducted. It opens with the IRS’s categorization of income into earned, portfolio, and passive—and quickly focuses in on how rentals are typically considered passive unless special rules apply (which might one of the reasons you are reading this). The chapter explains passive activity loss (PAL) limitations, which are anything but your pal, and the $25,000 exception available to many landlords, with phaseouts starting at $100,000 of modified adjusted gross income (MAGI).

The coveted Real Estate Professional Status (REPS) is introduced (but expanded in a later chapter), which, if met, allows rental losses to be treated as nonpassive and deductible against other sources of income including W-2 income. However, it also calls out California’s non-conformity with REPS under state tax law, meaning losses still face limitations even if you qualify federally. Yeah, sorry for the spoiler.

We also discuss rental property tax strategies. While rental properties are wealth-building or eventual lifestyle improvements first, they can also be a part of your tax reduction strategy. Other nuanced topics include vacation home rules, lots of them, and how states treat rental income and losses differently from the IRS, often complicating your filing requirements and increasing your tax burden. Not so good.

By Jason Watson, CPA
Posted Saturday, August 10 2024

This is aimed at the business owner real estate investor combo where there is a need to consider the business income as passive activity income. This would include the married couple where one person operates a business yet the household also has rental properties. Why do you care? For two big reasons- first, if you have other non-deductible passive losses due to income limitations, such as those from a rental property, you can now have your passive income absorb these passive losses. This allows you to enjoy your tax benefits now rather than delaying the pleasure to future years. Yay!

Second, as a passive owner you might be able to only draw distributions from your business (no salary) rather than salary plus distributions. Since you are pulling money from the business as passive income, this saves you several thousands of dollars in avoided Social Security and Medicare taxes. Every $10,000 in owner salary is about $1,500 in payroll taxes. Yay again!

The world is always trending towards harmony, so here are the passive business owner downsides. It is difficult to claim passive business owner given the material participation tests. The hardest one to overcome is #5 from IRS Publication 925 Passive Activity and At-Risk Rules. Here is the list from Treasury Regulations Section 1.469-5T–

(a) In general. Except as provided in paragraphs (e) and (h)(2) of this section, an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if-

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

IRS Publication 925 Passive Activity and At-Risk Rules cleans this up a bit and is more reader friendly. If this is your first brush with this material participation list, buckle up. You’ll see it in various forms including commentary in other portions of our book.

Let’s look at #5 again, but with some verbiage from the IRS Audit Techniques Guide (ATG) for Passive Activity Losses–

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

IRS ATG: An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity. Yikes (emphasis added).

IRS Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

In other words, you need to look back for 10 years and if 5 of those years had material participation by you in the business activity as defined by any of the above participation tests (1-7), then the IRS will disallow your passive activity claim including the claim of having passive activity income. Could you start a brand-new business without the history? Perhaps, but this might be viewed as an end-around especially if the new business magically looks, walks, talks and smells like the old. Transitioning from material participation to passive is certainly tough!

Just because you call yourself a limited partner in a limited liability limited-partnership (the triple-“L” P) or some other variant does not matter. It is all about your actions and the reliance on your participation by the entity or enterprise for its success. Should you be considered materially participating in the business, then your income will be typically considered self-employed income and subject to self-employment taxes (Social Security and Medicare taxes). If the entity is taxed as an S Corporation, then you would need to be paid a reasonable salary.

A quick recap- you would like to be considered a passive business owner to either-

• have passive losses be deductible against your newfound passive income,

• to avoid having to pay yourself a reasonable salary in an S Corp environment (and only take shareholder distributions), or

• have your income avoid self-employment taxes in a sole proprietor, single-member LLC or partnership environment.

However, the tax code has seen you (and a zillion others) coming a mile away and mostly says No unless you can slip and slide around the rules above.

By Jason Watson, CPA
Posted Saturday, August 10 2024

In 1986, the Reagan administration and Congress blasted away at passive losses or what others might have called abusive tax shelters. With the updated passive activity loss rules, only passive income could offset passive losses with the $25,000 real estate rental exception.

In the context of real estate and rental properties, you only have three basic options to deduct your activity’s losses-

• Fit into the narrow window for the $25,000 passive loss allowance for rental properties.
• Qualify as a real estate professional or what some call REPS.
• Have your rental activity qualify as a short-term rental with average guest stays 7 days or fewer with your material participation (which we discuss in a later section). This is also referred to as the short-term rental (STR) loophole.

A fourth option is to find some passive activity that throws off passive income. Ergo, the passive income generator or fondly referred to as a PIG. There are plenty of private equity funds or other real estate investments that can offer passive income. The income is passive since you are not materially participating in the investment.

Sidebar: Needless to say these investments must be heavily scrutinized. How much income can they really provide? What is your cost of equity versus the income generated including the value of using otherwise unallowed passive losses? What is the redemption policy (the exit plan and limitations)?

You can also invest in a business. This gets tricky of course since you cannot materially participate in the day-to-day operations, yet your money is invested (trapped?) into the entity. This can be unnerving. Keep in mind too that dividends and capital gains generated by a business, or what is called portfolio income, are not considered passive income even if your involvement in the investment is passive. In reviewing a K-1 from a partnership tax return, you will separate boxes for ordinary income, dividends, interest income and capital gains.

Are you a business owner? Could you deem your business income (profits) to be passive by not materially participating in the activity? Unlikely, at least for a while. We explore the rules on being considered a passive business owner in a later section.

Keep in mind the classic phrase- pigs get fed and hogs get slaughtered.