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

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

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

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

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

Trap #1: The Recapture Cash Call

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

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

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

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

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

Consider this nightmare scenario:

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

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

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

Trap #2: The Anatomy Of A Payment

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

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

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

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

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

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

Trap #3: The Imputed Interest Rule

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

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

IRC Section 483(a) reads-

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

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

The Foreclosure Risk (Section 1038)

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

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

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

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

Mortgage Exceeds Adjusted Basis

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

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

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

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

Rental Was Your Primary Home

According to IRC Section 121, there are two tests-

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

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

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

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

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

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

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

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

Let’s run through these two examples-

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

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

Consider-

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

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

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

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

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

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

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

Or

In this example, the property owner will pay-

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

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

Separate Structure Gains Exclusion

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

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

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

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

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

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

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

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

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

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

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

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

Passive Activity Losses Upon Disposition

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

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

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

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

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

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

We digress. Other tidbits-

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

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

Net Investment Income Tax

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

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

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

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

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

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

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

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

Here is a summary table for review-

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

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

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

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

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

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

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

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

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

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

Land (Bucket 1, with Arbitrage)

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

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

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

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

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

Use this to your advantage. How? Consider-

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

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

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

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

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

Fill that land bucket!

Building and Land Improvements (Bucket 2)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Personal Property (Bucket 3, The Section 1245 Trap)

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

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

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

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

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

Loose Assets (Thrift Store Value)

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

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

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

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

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

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

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

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

Sticky Assets (Functionality Value)

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

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

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

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

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

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

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

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

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

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

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

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

Ordering Your Price Allocations

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

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

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

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

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

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

Purchase Price Allocation Challenges

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

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

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

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

Cost Basis Audit

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

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

But!

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

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

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

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

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

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

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

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

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

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

Depreciation Recapture

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

• Ineligible Property

• Deadlines (time) and spend (money)

• 1031 Exchange Qualified Intermediary

• Section 1245 property (cost segregation woes)

• State Issues

Ineligible Property

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

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

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

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

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

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

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

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

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

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

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

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

Deadlines and Spend

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

• Replacement property must be identified within 45 days.

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

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

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

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

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

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

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

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

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

Fun!

1031 Exchange Qualified Intermediary

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

According to the IRS Fact Sheet 2008-18,

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

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

Personal Property (Section 1245)

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

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

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

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

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

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

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

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

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

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

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

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

State Issues with 1031 Like-kind Exchanges

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

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

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

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

What does all this mean?

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

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

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

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

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

Improvement 1031 Exchange

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

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

Lazy 1031 And Tax Arbitrage

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

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

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

Reverse 1031 Exchange

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

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

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

721 Exchange

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

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

Delaware Statutory Trusts (DST)

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

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

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

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

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

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

Ok, we spent a bit more time than expected.

Tax Bomb

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

Cost Segregation Study on Replacement Property

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

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

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

Revenue Procedure 2008-16

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

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

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

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

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

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

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

Some notables-

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

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

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

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

Pulling Money Out Your 1031 Like-Kind Exchange

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

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

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

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

Thoughtful Tax Planning with 1031 Exchanges

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

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

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

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

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

Problems with 1031 Exchanges

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

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

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

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

Summary of 1031 Like-Kind Exchanges

Here is a nice summary to wrap up this section-

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

By Jason Watson, CPA
Posted Sunday, December 14, 2025

There is a subtle difference between taking a rental property offline versus removing it from service. As we’ve discussed, renovations, repairs and improvements do not take the rental property out of service if it remains held for the production of income. Rather it is simply unavailable for occupancy (temporarily offline).

Here are some common reasons to no longer hold the property for the production of income and therefore take the rental out of service-

• You want to sell the rental property but it needs renovations first.
• Your mother is aging and you feel she should move into your rental property until she is ready for assisted living accommodations.
• It’s been a good run, and now you are wanting to use the rental property as a second home.

We could go on and on, right?

Deductions When Out of Service to Sell

Please recall our discussion regarding expenses between the closing date and available for rent date where several expenses are not deductible. A similar situation exists when the rental property is no longer held as available to rent.

If you take the rental property offline for renovations and you do not intend to rent it again, but rather sell it or convert to a primary or second home, the asset is no longer being held for the production of income.

This is the most common heartbreaker. You have a rental. The tenant moves out. You decide, “You know what? I’m tired of tenants. I’m going to renovate this place and sell it.” You just killed your rental business. By changing your intent from “holding for rent” to “holding for sale,” you have withdrawn the asset from the rental service.

Welcome to the Pit of Misery. Dilly dilly.

This is where tax deductions go to die. According to Treasury Regulation Section 1.168(i)-8, an asset is considered “retired” or “withdrawn” when you permanently remove it from use in your trade or business. Depreciation? Stops immediately. Operating Expenses? Generally become non-deductible personal expenses (or “investment expenses” that are permanently non-deductible because of OBBBA).

Still An Active Business (The Argument)

A real estate investor could argue that a rental property that meets the standard of being a trade or business, continues to do so while the property is being held for sale. Recall the definition of a “trade or business” which comes from common law. The Supreme Court has interpreted “trade or business” for purposes of IRC Section 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making a profit.

With respect to depreciation, there is some case law supporting this perspective. In Lenington v. Commissioner, Tax Court Memo. 1966-264, the court answered the question, “can petitioners deduct depreciation on poultry buildings after they ceased operating their poultry business but while the buildings were for sale?” The court reasoned as follows-

Since the poultry buildings were not abandoned or converted to personal use prior to 1962, but were involved in a discontinuance of the active conduct of the poultry business, their previously established character as business property was not changed.

The Rebuttal (Legislative Grace)

However, IRC Section 62(a)(4) reads-

(4) Deductions attributable to rents and royalties.
The deductions allowed by part VI ( Sec. 161 and following), by section 212 (relating to expenses for production of income), and by section 611 (relating to depletion) which are attributable to property held for the production of rents or royalties.

In a 1944 report from the Committee on Finance, Senate Report 885, 1944 C.B. at 877-878-

Similarly, with respect to the deductions described in clause (4), the term “attributable” shall be taken in its restricted sense; only such deductions as are, in the accounting sense, deemed to be expenses directly incurred in the rental of property or in the production of royalties.

1944 was a zillion years ago, agreed. However, in a 2001 Ninth Circuit appeal of Strange v. Commissioner, the court affirmed and referenced IRC Section 62(a)(4) in similar fashion by stating in part-

In this case, our task is to interpret I.R.C. § 62(a)(4), providing for deductions from gross income (“above-the-line deductions”). The Tax Court’s construction of this statute involves a question of law subject to de novo review. See Sliwa v. Commissioner, 839 F.2d 602, 605 (9th Cir.1988). Because tax deductions are a matter of legislative grace, statutes providing for them should be narrowly construed against the taxpayer. Deputy v. du Pont, 308 U.S. 488, 493, 60 S.Ct. 363, 84 L.Ed. 416 (1940).

Section 62(a)(4) provides for above-the-line deductions for expenses “attributable to property held for the production of rents or royalties,”

Matter of legislative grace. Narrowly construed against the taxpayer. Wow!

The “Yes… But” Trap

IRS Publication 527 Residential Rental Property reads in part-

Vacant while listed for sale.
If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold. If the property isn’t held out and available for rent while listed for sale, the expenses aren’t deductible rental expenses.

Did you catch the whiplash in that IRS blurb? It is contradictory-

• Sentence 1 says “Yes”: You can deduct expenses until the rental property is sold.
• Sentence 2 says “No”: …but only if it is still available for rent.

This is the “gotcha.” Most sellers want the property vacant for easy showings and a clean closing. But the moment you stop “holding it out for rent” (because you want it empty for the buyer), Sentence 2 kicks in and kills the deduction promised in Sentence 1. Don’t stop reading after the first period!

Alrighty then. We really beat that up. The bottom line is this- expenses, including depreciation, are no longer deductible once the rental property is not ready and available for rent and is listed for sale. There might be wiggle room for mortgage interest as a second home deducted on Schedule A of your individual tax return (Form 1040) along with property taxes.

Practical Advice

Ideally, you would keep the rental property occupied while you are wanting to sell. This could be good and bad; it is good if you are selling to another real estate investor, but bad if you are wanting to include families and those who do not want an existing tenant. Also, tenants will not share the same objective or motivation as you. Financial incentives might be required to align everyone’s interests.

Not all is lost on expenses incurred while selling. There might be some expenses directly related to the sale such as real estate commissions, marketing and advertising expenses, repairs or maintenance requested by the buyer, and all the other usual suspects. Some people argue that utilities, such as electricity to keep the rental property in good order for showings, are a selling expense, but this is not definitive.

Personal Use Creep And Inaction Drift

You kick the tenant out to renovate. The renovation drags on. You start using the place for weekend getaways or let your brother-in-law crash there rent-free while he “helps” with the painting. If you use the property for personal purposes for more than 14 days (or 10% of rental days), you risk reclassifying the property as a vacation home and your tax deductions and therefore losses are limited to your revenue (which is likely $0).

Moving on to inaction. In Newberry v. Commissioner, 76 T.C. 441 (1981), the Tax Court disallowed deductions because the owner couldn’t show a “continuous and regular” effort to rent the property. The owner argued the property was just “idle.” The court said no, it was “withdrawn” because there was no active intent to rent it. If you let the house sit for two years with no permits pulled and no work done, you aren’t renovating. You’re retired.

Keep your property in the “Temporarily Offline” zone. Keep the permit active. Keep the intent to rent again clear like the Subt tax court case. Stay out of the pit of misery.

Who wants a picture page?

By Jason Watson, CPA
Posted Sunday, December 14, 2025

This is the taxicab that is in the shop for a new transmission. It cannot take a passenger right now (so it’s not technically “Idle” or ready), but the owner has every intention of putting it back on the street next week. Next month, really, since a new transmission takes some time, right?

In rental terms, this is the “renovation” zone. You are doing more than just fixing a leak; you are gutting a kitchen or tearing out the 1970s shag carpet. This is a critical scenario to get right so you don’t fall into the “permanently withdrawn from use … in the production of income” pit of misery. Zones. Pits. More metaphors being mixed.

Can you deduct typical rental expenses such as mortgage interest, insurance, real estate or property taxes, utilities and HOA dues during renovations? The answer is a definite maybe.

Renovations Plus Intent To Produce Income

Because the rental property is not “ready and available,” an aggressive auditor might argue that you cannot depreciate it. They might point to the “Idle” definition we just discussed and say, “Hey, this place is a construction zone, not a rental. You can’t rent a house with no toilet.” To the pit of misery!

You simply pivot your argument. You admit that the property is not “Idle” (ready), but you argue that it is “Temporarily Offline.” Huh? In your full nerdy yet confident voice you say, “Yeah, but it was placed in service three years ago, and I never withdrew it. I just paused operations to improve the asset for future income production.” And then don’t blink. Don’t even look away. 1,000-yard stare.

Some kidding aside, the deciding factor comes from IRC Section 212 where the rental property must be considered to be property held for the production of income.

Specifically, the tax code reads-

As such, under subparagraph 2 above, if you can demonstrate that you genuinely intend to continue holding the property out for rental use and to produce income following the renovations, the ordinary and necessary expenses incurred are allowed rental property tax deductions in the interim.

Here is a win from Subt v. Commissioner, Tax Court Memo 1992-448, where the court allowed operating expense deductions for two years during renovations-

Section 212 allows as a deduction all the ordinary and necessary expenses paid during the year for the production or collection of income (sec. 212(1)) or for the management, conservation, or maintenance of property “held for the production of income” (sec.212(2)). Section 167(a)(2) allows as a deduction a reasonable allowance for depreciation of property “held for the production of income.” The phrase “held for the production of income” has the same meaning in section 212 and section 167. Mitchell v. Commissioner, 47 T.C. 120, 129 (1966). Expenses and depreciation may be deducted only if the property is held for production of income during the taxable year at issue. Meredith v. Commissioner, 65 T.C. 34, 41 (1975). Under section 1.212-1(b), Income Tax Regs., ordinary and necessary expenses paid or incurred in the management, conservation, or maintenance of a building devoted to rental purposes are deductible notwithstanding that there is actually no income therefrom in the taxable year.

The record supports a finding that petitioners held their Merle property during 1987 and 1988 for the production of income under section 212(2), and that some of the expenses they incurred during this period were for the management, conservation, or maintenance of property held for the production of income under section 212(2). The property was not used by them personally; the property had been rented in previous years; petitioners intended to rent the property in the future or sell it; and the reason why no income was produced by the property during the years in question was because of the ongoing renovations to the property. Additionally, petitioners ran several newspaper advertisements during 1988 offering potential tenants accommodations they would make to suit the needs of business occupants. The fact that the property realized no income during the years at issue is not determinative. Petitioners, therefore, are sustained on this issue.

Having found that petitioners held the property for the production of income within the meaning of section 212, it follows that depreciation, taxes, utilities, operating, and permit expenses are allowable for the 2 years at issue.

Yay!

Another way to look at the in-service versus out-of-service conundrum- once an asset (rental property) is placed into service, it remains in service until the intent to produce income with the asset no longer exists. During renovations or other offline activities, supporting your intent to produce income with the rental property in the future becomes important.

Partial Asset Disposition (PAD)

Before you leave the construction zone, here is one advanced move we discussed in an earlier chapter. When you renovate, you are often tearing out old components (like a roof, HVAC, or that terrible 1970s carpet) and replacing them.

As a reminder, you can choose to write off the remaining value of the old component immediately (called a Partial Asset Disposition). This gives you a nice tax deduction now because you are effectively “disposing” of the old roof, for example, before you capitalize the new one.

Many rental property owners skip this because calculating the value of an old roof is difficult (you need to use the Producer Price Index or other nerdy accounting methods). If you don’t dispose of the old asset, you simply continue depreciating it alongside the new one. You won’t get in trouble for this “double depreciation,” but you might be leaving a tax deduction on the table.

Expenses During Immediate Renovations After Closing (The Trap)

Yet another reminder from that same chapter, the IRS gets suspicious when you buy a property and immediately start major renovations because the asset was never technically “held for the production of income” per IRC Section 212. If the property is never placed in service before the rehab starts, your holding costs during that period may be capitalized under IRC Section 266 (otherwise they are lost deductions).

The safest strategy is a specific sequence of events: place the property in service, make a genuine effort to find a tenant, and then take it temporarily offline for renovations. This establishes the property as a rental business first, anchoring your deductions. Be warned that your efforts to rent must be legitimate; as seen in Meredith v. Commissioner 65 Tax Court 34 (1975), half-hearted attempts to find a tenant won’t satisfy the IRS or the Tax Court. Here is the quote-

To the contrary, we have found that petitioner’s rental efforts were spasmodic and halfhearted during the years in issue. We can only conclude that petitioner did not make a bona fide attempt to rent the property during these years.

Spasmodic? Mom is Ok with it, so you have that going for you.

Summary

As mentioned in this section and elsewhere, placing the rental property into service where it is ready and available for occupancy, and held out for rental use, is the first obstacle. If you can also demonstrate that the rental property is being held for the production of income, then expenses during vacancy may be deducted and time spent may be counted for material participation.

By Jason Watson, CPA
Posted Sunday, December 14, 2025

Think of an empty taxicab that does not have a passenger but is ready and available for one (lack of market). Alternatively, a taxicab is getting an oil change (repairs) and cannot accept a passenger. This is vacant yet idle, and operating expenses (OpEx) and depreciation keep on truckin’. Slight mix of metaphors between taxicabs, rentals, and trucks, but you get it.

Light Repairs

Painted. Clean. Sign in the yard. Waiting for a tenant. Fixing a minor leak under the toilet. Good to go!

You can also make the rental property unavailable for small periods of time to make repairs (beyond a simple leak but short of a renovation), or what the IRS calls managing, conserving and maintaining your investment, and be in the clear.

Lack of Market (No Business)

Your tenant moves out on Friday. You spend the weekend patching a few nail holes and touching up the paint (repairs). You put a “For Rent” sign in the yard on Monday. Tuesday comes and goes with no phone calls. Even though the property is vacant, it is only considered “Idle” due to a temporary lack of a market.

• Operating Expenses: Fully deductible (under IRC Section 212)
• Depreciation: Fully deductible (as described in IRS Pub 527)

To stay on the right side, the property must be “Ready and Available.” If a tenant showed up with cash in hand, could they move in?

• Yes? It is Idle. You are safe.
• No (because the kitchen is gutted)? It is beyond Idle. You have drifted into the “Temporarily Offline” zone. Unlike the friend zone with a girl you like, this one can be good (see our Vacant and Temporarily Offline section).

The Semantics Trap

However, be careful with your semantics. While the IRS publications use “Idle” as a positive (depreciation allowed), some tax court judges have used “Idle” as a negative synonym for “Abandoned.” In those losing cases, the rental property was idle not because of a lack of market, but because of a lack of intent. The owner simply stopped trying.

But this is incorrect usage. It is like people saying IRA when they mean 401k. Sure, both are about retirement, but they are very much different vehicles.

Having said that, most tax court cases and the accounting industry use vacant versus idle when it comes to discussing rental properties. You just need to add the “yeah but” and say “vacant, yes, but it is vacant because I can’t find a tenant” or “vacant, yes, but it is temporarily offline” which we will tackle next, and it’s a good one.

Expenses Immediately After Closing Before First Tenant or Guest

As a reminder from our chapter on initial asset management, if your rental property is not “ready and available” for occupancy, operating expenses like utilities, HOA dues, and insurance are generally not deductible under IRC Section 195 and Revenue Ruling 99-23. While you might salvage some mortgage interest and property taxes on Schedule A (subject to interest and tax limitations), the better answer is to get the property “in-service” immediately.

You do not need professional staging or a VRBO listing to start the clock; you simply need a habitable dwelling and a genuine willingness to rent. For example, if you buy a ski condo in September, listing it immediately counts as “operating” even if the market is dead until Thanksgiving. The goal is to avoid “pre-rental status” by making the unit available first, even if you are simultaneously doing minor cosmetic work like painting.

By Jason Watson, CPA
Posted Sunday, December 14, 2025

You could purchase a property and only hold it for investment purposes (speculation, appreciation). It is not a rental property since it is not available and ready for a tenant or guest stay. In this case, your operating expenses cannot be deducted. Why? Investment expenses went away with the Tax Cuts and Jobs Acts (TCJA) as a miscellaneous deduction and was made permanent with the One Big Beautiful Bill Act (OBBBA).

Sure, it is being held for the production of income, but as a passive investment, not a rental business. That distinction changes everything. That changes things as you can see. Can you elect to capitalize the expense of maintaining your investment under IRC Section 266? Unlikely, since this code allows you to capitalize carrying charges for unimproved land or property under construction. It does not allow you to capitalize the costs of maintaining a standing, improved building that is simply sitting empty.

You might be able to deduct mortgage interest and property taxes as a second home. But the utilities, insurance, and HOA dues? Gone forever. Not just forever, but forever and ever.

By Jason Watson, CPA
Posted Sunday, December 15, 2025

This is a mini series with a total of five sections- the tease or intro, and the four sections describing each scenario. Before we get into that, here are two pieces of verbiage from IRS Publication 527 Residential Rental Property–

Idle Property
Continue to claim a deduction for depreciation on property used in your rental activity even if it is temporarily idle (not in use). For example, if you must make repairs after a tenant moves out, you still depreciate the rental property during the time it isn’t available for rent

Vacant rental property.
If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. However, you can’t deduct any loss of rental income for the period the property is vacant.

We’ll introduce another term that is not found in tax code or publications but will prove to be useful-

Temporarily Offline
As long as you can prove a renovation is temporary and you intend to rent it again (as seen in Subt v. Commissioner Tax Court Memo 1991-429 in a following section but you need to wait for it), the property is not considered a “permanently withdrawn from use” as described in Treasury Regulations Section 1.168(i)-8(b)(2).

As such, it remains “Placed in Service,” allowing you to continue depreciating the building structure. “Held for the production of income” allows you to continue deducting operating expenses even though it isn’t currently ready and available for a tenant or guest. Yes, you need both to fully deduct both depreciation and expenses.

How is idle different than vacant? The IRS publication is terribly vague (shocker, we know) and perhaps duplicative suggesting that idle and vacant are synonymous. Practically they are, but technically they are not.

To be fair, the idle property blurb is under a section on depreciation whereas vacant rental property is under a section on types of deductible rental property expenses. Also, idle property is not limited to rental properties- it can be applied to any asset associated with a business activity including real estate. Your machinery cannot be vacant but it can be idle.

Vacant, idle, temporarily offline and blah blah blah all seem to be intermixed and confusing. You are correct, and we will attempt to uncomplicate the confusing. Why do you care as a rental property owner? Let’s explore four scenarios-

• Vacant and Held For Investment Only (speculation play)
• Vacant and Idle (lack of market, light duty repairs)
• Vacant and Temporarily Offline (renovations intent to rent again)
• Vacant and Withdrawn From Service (reno to sell, conversion to personal use)

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

Here are some FAQs you might find helpful as a chapter summary-

Can I deduct expenses incurred immediately after closing but before placing the rental property in service?
Generally no. If the property is not yet ready and available for rent, expenses like mortgage interest, taxes, insurance, and utilities are not deductible as rental expenses. According to IRS Revenue Ruling 99-23 and IRC Section 195, these costs are considered pre-rental and must be capitalized or may be partially deductible under other provisions (e.g., property taxes on Schedule A if applicable). Yuck.

Can I deduct mortgage interest during a renovation?
Not if the property is not in service. You may elect to capitalize it under IRC §266 instead. You will find yourself in this situation typically if you buy a rental, never make it available for rent, and immediately start renovations.

What expenses can I deduct if I start renovations after the property has already been a rental?
If the property was previously placed in service and you continue to hold it for the production of income, you may deduct ordinary and necessary expenses under IRC §212—even if no income is earned during the renovation period. This includes mortgage interest, taxes, insurance, and utilities, provided there is no personal use.

What’s the tax strategy to maximize expense deductions for immediate renovations?
To ensure expenses are deductible, first place the property in service—meaning it is ready and available for rent—and then take it offline for renovations. This sequence meets both the “in-service” and “held for production of income” standards under IRC Section 212 and Treasury Regulations Section 1.46-3(d)(1)(ii). Yay!

What are “carrying costs”?
Carrying costs include mortgage interest, property taxes, utilities, insurance, and maintenance costs incurred while the property is not yet in service.

Do I have to capitalize interest and taxes on an idle property?
No. It’s optional, but capitalization might be more beneficial when the rental property is offline and not generating income. Typically, most rental property owners will expense it which might be subject to passive activity loss limitations.

What happens when I change a rental from long-term to short-term?
You switch from 27.5-year to 39.0-year depreciation. However, this is typically not a change in accounting method.

Can I use bonus or Section 179 depreciation during a change in use?
No. Neither bonus depreciation nor Section 179 can be used in the year of change-in-use.

Neat, what is a change in use?
The most common are going from long-term to short-term, and vice versa. In the context of bonus depreciation and Section 179 above, going from a primary residence to a rental property is a change in use technically, but the asset was not placed in service prior to change in use (so, you are good with Section 179 and bonus).

Is depreciation recapture triggered by a use change?
No. It is not triggered until the asset is sold or taken out of service (its intent is no longer to produce income such as moving back into as a home).

Is depreciation recapture triggered when business use falls below 50%?
This is nuanced. If you used IRC Section 179 expensing, then Yes. If you used bonus depreciation, then under IRC Section 280F(b)(2), only listed property is recaptured- all IRC Section 1245 property identified by a cost segregation study is not considered listed property.

When is a rental considered “out of service”?
When it is no longer held for the production of income, such as converting it into a second home or letting family live there for free. Didn’t we just say that?

Can I deduct expenses while a property is out of service?
Only expenses related to holding the asset for sale (e.g., property taxes). No operational deductions are allowed.

Does renovation take a property out of service?
No, as long as your intent to produce income remains and will remain after renovations (i.e., putting the rental back online), and the property is not being used personally.

Can I increase my basis after buying out a partner?
Yes—by filing an IRC Section 754 election, you can step up your inside basis to reflect your additional purchase price. Very common. Often over-looked by tax professionals.

Does the 754 election affect depreciation?
Yes. The step-up amount is depreciated, creating an additional deduction for the acquiring partner.

What is the difference between idle and vacant property?
They’re often used interchangeably, but technically, idle means not in use yet still held for producing income. Vacant means available but unoccupied. Idle is most often used with machinery and whatnot, whereas the context of rental properties usually use vacant.

Are rental operating expenses deductible if I can’t find tenants or guests right away?
Yes, but only if your efforts to rent the property are genuine and documented. You must demonstrate that the property is held out for rental use. If your actions suggest minimal or insincere attempts to find renters (as in Meredith v. Commissioner), the IRS may disallow those deductions.

Can I claim depreciation on vacant rental property?
Yes, if it remains held for income-producing purposes, like during tenant turnover or repairs.

What if I plan to sell me vacant rental property?
If it’s no longer held out for rent use (i.e, the production of income) and is instead held for sale, depreciation and operational deductions might be limited.

What is a Delaware Statutory Trust (DST), and how is it used in real estate?
A DST is a legal entity that allows multiple investors to co-own fractional interests in real estate. DSTs are commonly used in 1031 exchanges to defer capital gains taxes. They can help meet tight identification deadlines, avoid debt qualification requirements, and serve as backup options when replacement properties are limited.

What are the downsides of investing in a DST?
DSTs offer limited control and liquidity. Investors cannot make property-level decisions and may find it difficult to exit the investment early. DSTs are regulated as securities, so they require careful due diligence and are not ideal for hands-on investors seeking flexibility or active involvement.

Can I exclude the gain on an ADU when I sell my primary residence?
Not entirely. Under IRC Section 121 and Treasury Regulations Section 1.121-1(e), you generally cannot exclude gain from the sale of a separate structure (like an ADU) used for rental or business purposes, unless you lived in it for at least 2 of the last 5 years before the sale. Lots of rules.

How is gain calculated when part of my property was used as a rental?
You must allocate both the sales price and the cost basis between the residential (personal use) and nonresidential (rental/business) portions. Gain on the personal residence may be excluded under Section 121, but gain on the rental portion is taxable and subject to depreciation recapture. More rules and possibly complex and unfavorable math.

Is there a way to reduce the taxable gain on the rental portion?
Possibly. You can obtain an appraisal or broker’s price opinion to assign a smaller value to the rental portion (like an ADU). While this won’t eliminate the tax, it may reduce the allocated gain. However, it must be reasonable and supportable.

Are rental property sales always subject to NIIT?
Not always. NIIT can be avoided if you qualify for Real Estate Professional Status (REPS), use the short-term rental loophole, or provide substantial services (like a hotel) and materially participate in the activity.

Can material participation alone avoid NIIT for long-term rentals?
No. Even with material participation, gains from long-term rentals are still subject to NIIT unless one of the specific exceptions (like REPS or hotel-like services) applies.

How do gains from rental property sales affect MAGI and NIIT?
Gains from the sale increase your MAGI, potentially pushing you over the NIIT threshold and triggering the tax. For example, a $500,000 gain added to a $50,000 W-2 salary would subject part or all of that gain to the 3.8% NIIT.

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

There are three primary situations when it comes to mortgage interest and other carrying costs during construction including renovations. There might be others, but here we go-

• You build a rental property from scratch.
• You own a rental property and take it offline to start over-priced renovations and improvements.
• The rental property is not in service for whatever reason, but is also not undergoing construction, renovations or improvements (bad).

Treasury Regulations

Let’s look at Treasury Regulations Section 1.266-1 first. The first paragraph reads in part-

(a)(1) In general. In accordance with section 266, items enumerated in paragraph

(b)(1) of this section may be capitalized at the election of the taxpayer.

Next, 1.266-1(b) reads-

(b) Taxes and carrying charges.
(1) The taxpayer may elect, as provided in paragraph (c) of this section, to treat the items enumerated in this subparagraph which are otherwise expressly deductible under the provisions of Subtitle A of the Code as chargeable to capital account either as a component of original cost or other basis, for the purposes of section 1012, or as an adjustment to basis, for the purposes of section 1016(a)(1). The items thus chargeable to capital account are:

(i) In the case of unimproved and unproductive real property: Annual taxes, interest on a mortgage, and other carrying charges.

(ii) In the case of real property, whether improved or unimproved and whether productive or unproductive:

(a) Interest on a loan (but not theoretical interest of a taxpayer using his own funds),

(b) Taxes of the owner of such real property measured by compensation paid to his employees,

(c) Taxes of such owner imposed on the purchase of materials, or on the storage, use, or other consumption of materials, and

(d) Other necessary expenditures, paid or incurred for the development of the real property or for the construction of an improvement or additional improvement to such real property, up to the time the development or construction work has been completed. The development or construction work with respect to which such items are incurred may relate to unimproved and unproductive real estate whether the construction work will make the property productive of income subject to tax (as in the case of a factory) or not (as in the case of a personal residence), or may relate to property already improved or productive (as in the case of a plant addition or improvement, such as the construction of another floor on a factory or the installation of insulation therein).

Yawn. Let’s break this down a bit into chunks to make some sense of it all.

First, the phrase “chargeable to capital account” generally means the expense may be capitalized and added to the cost basis of the rental property. In turn, this capitalized expense may be depreciated over time.

Second, there is a slight distinction between raw land that is unimproved and unproductive, and other real property that might be improved or unimproved, and might be productive or unproductive. This is a subtle distinction but can be read as new construction and renovations.

Third, note that Section 1.266-1(b)(1)(ii), the renovations part if you will, has a catchall “other necessary expenditures.” This would naturally include insurance and utilities, on top of mortgage interest and property taxes.

Fourth, if you read beyond what is detailed here, the term “project” is used frequently. Treasury Regulations 1.266-1 define “project” as-

For purposes of this section, a project means, in the case of items described in paragraph (b)(1)(ii) of this section, a particular development of, or construction of an improvement to, real property, and in the case of items described in paragraph (b)(1)(iii) of this section, the transportation and installation of machinery or other fixed assets.

Importance of Capitalizing Carrying Costs

Why should you care about this gibberish? Recall that if the rental property is not in service (ready and available for occupancy, and held out for rental use), it reverts to an investment property or a second home, and you are severely limited on tax deductions. Property taxes and mortgage interest might be limited. Insurance, utilities and HOA dues, and related expenses, are all suddenly non-deductible. Bummer.

However, if your rental property is taken offline for renovations, the expenses above are generally deductible as operating expenses if your intent is to continue holding the property to produce income. Sure, they might be again limited because of passive activity loss limitations, but they are either deductible when you have net rental income (profits) or when you sell the property.

So, how can you find yourself in a pickle? If you purchase a rental property and immediately start renovations, you will need the benefit of IRC Section 266 to capitalize these expenses for later depreciation and deduction.

Mechanics of How This Works

The mechanics of capitalizing certain carrying costs during construction or renovations takes a bit of math. Let’s say you are renovating a kitchen immediately after closing and the rental property is unavailable for 64 days. This is about 17.5% of the year, with the inverse being 82.5% as in-service time (yeah, we are assuming a Jan 1 purchase date which is a bit unrealistic, but whatever). Here is a table showing the math-

Some items to note- “OpEx” is nerdy accounting speak for operating expenses, and “CapEx” refers to capital expenditures (not expenses). Yeah, sure, CapEx usually refers to buying something bigger, better, shiny and new, but it is fun to say OpEx and CapEx when illustrating the effects.

Next, certain expenses will remain 100% operating expenses such as advertising, management fees, sales tax, among others, since these expenses were incurred during the rental property’s in-service period.

Let’s say you spend $60,000 on the kitchen renovation. You would book the asset on your tax return’s fixed asset listing as $65,548 with the $5,548 representing the capitalized carrying costs.

IRC Section 266 Election Verbiage

Here is a sample election ripped off from our tax software that is attached to a timely filed tax return including extensions-

Pursuant to Internal Revenue Code § 266 and Treasury Regulation § 1.266-1(b), the taxpayer elects to capitalize carrying charges incurred during the taxable year [e.g., 2024] for the following property:

Property Address: [Insert rental property address]
The taxpayer is capitalizing the following types of carrying charges related to the above property:

Utilities (e.g., electricity, gas, water)
Insurance
Mortgage interest
Property taxes
Maintenance and security expenses

These costs were incurred prior to the property being placed in service for rental use, and are being capitalized to the basis of the property under this election.

Riveting.

Bonus Depreciation and Section 179 Expensing

Here is an example of a small work-around. Let’s say you take the rental property offline for two weeks to replace the carpet with tile since carpet is generally gross in a rental environment. The cost is $15,000, and you’ve calculated another $1,200 in carrying costs.

Assuming this tile renovation does not qualify for any repair safe harbor (de minimis, small taxpayer, routine maintenance) and it likely does not, you would record a $16,200 asset associated with the rental property. Would this tile renovation be eligible for bonus depreciation or Section 179 expensing? Typically, No, since tile is mortared to the floor structure and considered attached, and therefore would be depreciated over the life of the building.

Ok. Let’s say that carpeting is not that gross in a rental environment since you never use the property personally, and you spend $16,200 replacing it (that would be some fancy carpeting, but let’s roll with it). Good news! According to IRS Publication 948 How To Depreciate Property, this carpeting asset would generally be considered 5-year property and eligible for bonus depreciation and possibly Section 179 expensing should your rental property activity be considered a trade or business (regular and continuous involvement with a profit motive). See our accelerated depreciation and Section 179 deduction section on page 287 for more information.

Do you want more? Of course you do! Some people argue that carpeting in a basement is glued down versus tacked down, and is more aligned with tile in our example above. In other words, it is attached to the floor structure of the foundation and basement concrete.

As you can see, this gets tricky.

Gaming the System

We can see your wheels turning already- you take the rental property offline for six months to replace a couple of light bulbs. Since your family is helping, you call this a project, and capitalize otherwise non-deductible expenses for later depreciation. Of course, this is facetious and dripping with sarcasm, but at the same time whether you are stuck with non-deductible expenses or you elect to capitalize these same expenses as carrying costs under IRC Section 266 is the million-dollar question.

Just Purchased the Rental Property

As mentioned elsewhere, the time between when you close on the rental property and get the property ready and available for rent is no-man’s land. Must we now say no-person’s land? No landlord’s land is a mouthful. Regardless, this period of time between purchase and in-service date needs to be as small as you can make it since some rental property expenses are either limited or non-deductible because they don’t qualify as carrying costs (bad), or you need to be claiming renovations where these expenditures are capitalized (not good, but better).

Sidebar: As a reminder, the in-service date is not your first rented day. It is the date that the rental property is ready and available for occupancy, and held out for rental use through advertising and related efforts. This makes sense- the asset is deployed for its intended purpose. See our rental property in service defined section on page 85 for more information.

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

Chapter 11 addresses how to handle the financial and tax implications of rental property operations beyond the acquisition phase. The chapter focuses on issues such as interest capitalization during construction, the use of carrying costs, asset dispositions, and ownership changes. These topics are often overlooked but become important as your real estate activities grow in scale or complexity, or hopefully both!

The chapter begins with interest capitalization—when and how to treat mortgage interest as part of the building’s cost rather than an immediate deduction. It then moves to related items such as utilities and property taxes during development, and how to determine whether these should be expensed or capitalized. There is also a review vacant versus idle property, and how they are the same and different.

Additional topics include how to handle a partner buyout, transfer ownership interests, and take a rental property out of service. These scenarios are framed around IRS guidance and common accounting practices for property owners and managers.

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

You and two partners buy a $600,000 rental property together by contributing $200,000 each. Some time goes by, and one of your partners wants out. The rental property is now worth $750,000 so you pay them $250,000 (the increase in value was $150,000 or $50,000 per partner plus the partner’s original contribution).

However, per the general rule, the inside basis of the rental property is transferred to you without any adjustment. Yuck. In other words, your inside basis is $400,000 and the other partner’s basis is $200,000 for a total of $600,000 (let’s assume no depreciation). What is inside basis?

“Inside” basis is the total equity the partnership has in its assets, whereas “outside” basis is each partner’s tax basis in their share of the ownership. At the formation of a partnership inside and outside basis are usually equal (there are times when appreciated property is contributed, such as real estate, where the contributing partner’s outside basis is less than the inside basis which would be fair market value of the real estate).

Sidebar: The IRS requires that you track outside basis, and while your capital account might be negative, your outside basis generally cannot.

Should the partnership entity in our example sell the rental property outright for $750,000, the entity would have a taxable gain of $750,000 less $600,000, or $150,000, with your portion being 2/3 or $100,000. The problem is that you paid or contributed a total of $450,000 (your original $200,000 plus the $250,000 to buy out one of the original partners).

Your taxable gain should be $750,000 x 2/3 or $500,000 less $450,000, or $50,000. However, according to the books, your taxable gain would be $750,000 x 2/3 less $400,000, or $100,000 since the inside basis does not automatically adjust upon transfer from the departing partner to you.

What can be done is an IRC Section 754 election to increase your inside basis in the underlying asset by the additional amount paid to the departing partner. In our example this was $50,000.

Here is a table to highlight Fred buying out Shaggy.

Without a 754 election, the step-up portion column would not exist, and Fred’s inside basis would be $400,000 with a gain of $100,000. Also, keep in mind that we not considering depreciation matters including downstream depreciation recapture. Those issues can get tricky. Our intent was to highlight the basics of an IRC Section 754 election.

Sidebar: This is straight from the IRS website on FAQs for 754 elections- “An IRC Section 754 election allows a partnership to adjust the basis of the property within a partnership under IRC Sections 734(b) and 743(b) when one of two triggering events occur: 1) a distribution of partnership property or 2) certain transfers of a partnership interest. These adjustments can only be made if the partnership has made an election under IRC Section 754.” There you go.

By Jason Watson, CPA
Posted Monday, August 5 2024

What is the difference between 27.5 years and 39.0 years for rental property depreciation? 27.5 years is used primarily for residential properties whereas 39.0 years is used for commercial properties including nonresidential properties.

Recall in our discussions about Qualified Improvement Property (QIP) where we defined nonresidential properties. We started with IRC Section 168(e)(2) which states that residential properties obtain rental income from dwelling properties. Within the same section, a dwelling unit does not include transient tenants or guests. Later, in a Private Letter Ruling, the IRS defined transient tenants as those who stay 30 days or less.

As such, if your rental property has tenants who stay 30 days or less, it is considered nonresidential and is depreciated over 39.0 years. This was a quick summary. A more in-depth analysis was done in our section on QIP.

Why did the IRS, Treasury, Congress and everyone define it this way? The original intent was to prevent real estate investors from using 27.5 years of depreciation versus 39.0 years. In other words, by calling a rental property a residential property, they were able to shrink the depreciation schedule (and increase current year depreciation deductions).

Two scenarios might exist in what the regulations call a change in use-

• You have a long-term rental that you convert into a short-term. Going from 27.5 years to 39.0 years.

• You have a short-term rental that you leveraged for your big cost segregation study and accelerated depreciation, and now you are tired of the Airbnb and VRBA headaches. Plus, your community is pushing back on guests with an average stay of 7 days or less. As such, you give in, and convert the rental to long-term. Going from 39.0 years to 27.5 years.

The question becomes- is this change in depreciation considered a change in accounting method that would otherwise require Form 3115 to be filed? Short-answer, No.

A change in computing the depreciation allowance in the year of change for property is not a change in method of accounting. Specifically, Treasury Regulations Section 1.168(i)-4(f) reads-

(f) No change in accounting method. A change in computing the depreciation allowance in the year of change for property subject to this section is not a change in method of accounting under section 446(e). See § 1.446-1(e)(2)(ii)(d)(3)(ii).

Treasury Regulations Section 1.446-1(e)(2)(ii)(d)(3)(i) and (ii), deep deep deep into the regulation, reads in part-

(3) Changes in depreciation or amortization that are not a change in method of accounting. Section 1.446-1(e)(2)(ii)(b) applies to determine whether a change in depreciation or amortization is not a change in method of accounting. Further, the following changes in depreciation or amortization are not a change in method of accounting:

(i) Useful life. An adjustment in the useful life of a depreciable or amortizable asset for which depreciation is determined under section 167 … is not a change in method of accounting.

(ii) Change in use. A change in computing depreciation or amortization allowances in the taxable year in which the use of an asset changes in the hands of the same taxpayer is not a change in method of accounting.

Longer Recovery Period (27.5 to 39.0 Years)

Treasury Regulations 1.168(i)-4(d)(4) reads in part-

Change in the use results in a longer recovery period and/or a slower depreciation method—(i) Treated as originally placed in service with longer recovery period and/or slower depreciation method.

In this case you would adjust the remaining depreciation schedule to reflect 39.0 years as if 39.0 years was selected originally when the rental property was placed in service.

Shorter Recovery Period (39.0 to 27.5 Years)

Treasury Regulations 1.168(i)-4(d)(4) reads in part-

(3) Change in the use results in a shorter recovery period and/or a more accelerated depreciation method—(i) Treated as placed in service in the year of change.

This one is a bit more onerous since you don’t get “time credit” for the years the rental property was already in service and being depreciated. For example, if you are on year 5 and flip from 39.0 to 27.5 years, you would have 4 years of historical depreciation plus another 27.5 years of remaining depreciation.

Property affected by the change-in-use regulations is not eligible for bonus depreciation deductions in the year of change or IRC Section 179 expensing.

Personal Property

This section only considers changes in depreciation under IRC Section 167 and we intentionally omit changes under IRC Section 168 in connection with Section 167 which is for tangible property. Specifically, and with full nerdy accounting lingo, IRC Section 167(a) permits a depreciation deduction for the exhaustion and wear and tear of property used in a trade or business or held for the production of income (like rental properties).

IRC Section 168 sets forth the methods, periods, and conventions by which a rental property owner can depreciate tangible property as permitted by IRC Section 167(a). You would likely see tangible property or what some would call personal property be depreciated separately as a result of a cost segregation study.

Feel better? Unlikely. Our apologies.

By Jason Watson, CPA
Posted Monday, August 5 2024

The question comes up often where a real estate investor does not want to mess with rental property depreciation for whatever reason and decides against deducting it on their tax returns. The most common reasoning is- why depreciate my rental property since I cannot deduct the rental loss on my tax returns?

This will bite you because according to IRS Publication 544 Sales and Other Dispositions of Assets–

The greater of depreciation allowed or allowable (to any person who held the property if the depreciation was used in figuring its adjusted basis in your hands) is generally the amount to use in figuring the part of the gain to be reported as ordinary income. If you can show that the deduction allowed for any tax year was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation.

What does this mean? Generally, if you don’t deduct rental property depreciation, when you sell the property, you will be required to recapture depreciation as if you deducted it. Yuck. However, if you didn’t deduct rental depreciation on prior tax returns, you can easily fix it with a Form 3115 Application for Change in Accounting Method and Section 481(a) adjustment.

Allowed is what you claimed and deducted. Allowable is what you should have claimed and deducted. Keep in mind that just because depreciation deduction does not immediately help you because of passive loss limitations, you will benefit when either a) you sell property or b) have rental income (profits) in the future. As such, you should always (which is a big word) depreciate your rental property. We have a section on selling your rental property on page xx.

In related news, Canada allows rental property owners to opt out of depreciation entirely. Who knew? Makes sense when most real estate appreciates and doesn’t depreciate, right? Here is another gee whiz consideration- Canada calls it Capital Cost Allowance (CCA).