7791 / What are the tax benefits of real estate investment? What limitations may restrict enjoyment of those benefits?

The rental and management of real property is generally considered a trade or business even if the owner owns only one property,¹ is actively engaged in another profession or business and carries on all management activities through an agent,² or, continuously, over a period of several years, experiences losses from the operation of the business.³ However, it has been held that where activities were minimal, rental of a single residence was not a trade or business.⁴

Credits

Credits against tax liability may be taken for certain investments in low-income housing (See Q 7801) or rehabilitation of old or historic structures. See Q 7808.Use of these credits may be subject to certain limitations. See heading “Limitations” below.

Depreciation

An owner of residential or nonresidential improved real property (either used in a trade or business or held for the production of income) may deduct each year amounts for depreciation of the buildings, but not the land itself, even though no cash expenditure is made. Furthermore, the depreciable amount is not limited to the owner’s equity in the property.⁵ See Q 716. However, the deductions may be subject to certain limitations. See heading “Limitations” below. Also, where accelerated depreciation is used, which would not be true for residential rental property or nonresidential real property placed in service after 1986, part or all of the amount deducted is subject to “recapture” on sale of the property. See Q 7836. See Q - Q for more information on the bonus depreciation rules.

The 2025 OBBB restored 100 percent bonus depreciation with respect to property placed in service after January 19, 2025 (the 100 percent provision is permanent).

“Bonus depreciation” was previously extended by the 2017 tax reform legislation. While the bonus depreciation provisions were extended through 2027, the depreciation percentage was phased out based upon the date the property is placed in service, as follows:

• Property placed in service after September 27, 2017 and before January 1, 2023: 100 percent expensing.


• Property placed in service after December 31, 2022 and before January 1, 2024: 80 percent expensing.


• Property placed in service after December 31, 2023 and before January 1, 2025: 60 percent expensing.


• Property placed in service after December 31, 2024 and before January 1, 2026: 40 percent expensing.


• Property placed in service after December 31, 2025 and before January 1, 2027: 20 percent expensing.


• 2027 and thereafter: 0 percent expensing.⁶

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Planning Point: In other words, absent the 2025 OBBBA, bonus depreciation would have been limited to 40% for the 2025 tax year.

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Interest

An investor in improved or unimproved real estate may generally deduct each year amounts paid for mortgage interest (subject to certain limitations, See heading “Limitations” below (the 2017 tax reform legislation generally limited the mortgage interest deduction to $750,000 for 2018-2025 and the 2025 OBBBA permanently retained this $750,000 limit). However, prepaid interest must be deducted over the period to which the prepayment relates.⁷ A further limitation on deduction of interest is that construction period interest must be capitalized.⁸ The interest subject to capitalization may not be reduced by interest income earned from temporarily investing unexpended debt proceeds.⁹

Taxes

An investor in real property is permitted to deduct amounts paid for real property taxes (subject to certain limitations, See heading “Limitations” below).¹⁰ In the year of acquisition the buyer may deduct the real estate taxes allocable to the number of days the buyer owns the property.¹¹ “Taxes” that are actually assessments for improvements (e.g., sidewalks, sewers, etc.) and that enhance the value of the property cannot be currently deducted, but must be added to the investor’s basis in the property (i.e., capitalized) and deducted through depreciation allowances over the recovery period.¹² A further limitation on deduction of real estate taxes is that construction period taxes must be capitalized.¹³

Expenses

An investor in real estate may deduct each year “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”¹⁴ and all ordinary and necessary expenses paid or incurred during the taxable year (1) for the production and collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.¹⁵ See also Q 8049 and Q 8051.Routine repair and maintenance expenses are deductible in the year paid as business expenses or expenses incurred in connection with property held for the production of income, but the cost of improvements must be capitalized (added to the owner’s basis in the property) and recovered through depreciation deductions.¹⁶ Amounts paid for repairs are deductible if the amounts paid are not otherwise required to be capitalized.¹⁷ Capital improvements increase the value, prolong the life, or alter the use for which the property is suitable.¹⁸

The first $5,000 of “start-up” expenses is deductible, but not until the year in which the business begins, and the rest must be amortized over a 180-month period, beginning with the month the business begins. The $5,000 figure is reduced by the amount that start-up expenses exceed $50,000. Expenses included in this category are those (other than interest and taxes) incurred in connection with investigating the creation or acquisition of a new business, creating an active trade or business, and “any activity engaged in for profit and for the production of income before the day on which active trade or business begins.” The expenses must be expenses that would be deductible if incurred in connection with an existing active business.¹⁹

Generally, accrual basis taxpayers may not deduct expenses payable to related cash basis taxpayers before the amount is includable in the income of the cash basis taxpayer. The rule applies to amounts accrued by a partnership to its partners, by partners to their partnership, by an S corporation to its shareholders, and by shareholders to their S corporation. Related parties also include those discussed in Q 701.²⁰

Disposition

On disposition of the property, the owner may generally defer tax on gain by exchanging it for “like kind” property (under the 2017 tax reform legislation, like-kind exchange treatment applies only to exchanges of real property beginning in 2018 (this provision is permanent)). See Q 7839, Q 7840, Q 710. Alternatively, the buyer may be able to spread out the recognition of gain by using the installment method of reporting; however, an interest surcharge applies to certain installment sales of property with a sales price exceeding $150,000. See Q 667.Furthermore, the installment method of reporting is unavailable for sales of real property held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business.²¹

Because of IRC Section 1231, net losses on disposition may be treated as ordinary losses instead of capital losses, unlimited by the $3,000 cap on the ordinary income offset by capital losses. See Q 7834 for discussion of gain or loss on sale.

Special Benefits and Limitations

Special benefits or limitations may apply to certain kinds of real estate investment: low-income housing (see Q 7800), “rehabs” (see Q 7808), and vacation homes (see Q ). In addition, an investor can develop vacant land within limits without being classified as a “dealer.” See Q .

As a general rule, an investor takes the same deductions and credits and recognizes income whether the investor owns the property directly or has an interest in a limited partnership that “passes through” the deductions, credits, and income. See Q regarding regular partnerships and Q regarding electing large partnerships. However, if a publicly traded partnership is taxed as a corporation (see Q ), investors are unable to take partnership deductions, credits, and income on their own tax returns.

Limitations

If the property is used in an activity in which the investor does not materially participate, deductions and credits are subject to the passive loss rules; however, if the property is used in a rental real estate activity in which an individual actively participates, a special exemption for up to $25,000 of passive losses and the deduction-equivalents of credits with respect to rental real estate activities may apply. Active participation is not required with respect to the low-income housing or rehabilitation tax credits. See Q .

Losses incurred after 1986 with respect to real estate activities are subject to the “at risk” limitation. See Q .