Real estate is a timing business. So is the tax on it.
Depreciation on a rental is not hard to generate. The work is in being allowed to use it against a high W-2 — and in knowing, before you buy, what it will cost you when you sell.
Cost segregation moves the deduction forward
A residential rental is depreciated over 27.5 years by default; commercial over 39. A cost segregation study reclassifies parts of the building into 5-, 7-, and 15-year property that qualifies for bonus depreciation.
The default depreciation schedule treats the whole purchase price (less land) as one long-lived asset. An engineering-based cost segregation study breaks it apart: appliances, flooring, cabinetry, and specialty electrical are 5- or 7-year property; land improvements — paving, fencing, landscaping — are 15-year property. Those shorter-lived components are eligible for bonus depreciation in the year the property is placed in service, at whatever percentage is in effect for that year.
On a typical single-family or small multifamily rental, 20–35% of the depreciable basis lands in the short-lived classes. On a purpose-built short-term rental with furnishings, more. That is a large first-year deduction. Whether it does anything for you depends entirely on the next section.
The study is only worth commissioning if the resulting loss is usable. Before we order one, we determine which door through §469 you can actually walk through — if any.
Three doors through the passive loss rules
Rental losses are passive by definition. Passive losses can only offset passive income — unless you qualify for one of three exceptions. For a household earning $400,000+, only two of them are real.
The $25,000 allowance
Up to $25,000 of loss
Phases out $100k → $150k MAGI
The exception most people have heard of. It is fully phased out at $150,000 of modified AGI.
Real estate professional status
More than half of all personal services
Material participation per activity (or aggregate)
Removes the per-se passive label from your rentals. Nearly impossible with a full-time W-2 — but often achievable for a spouse, and the test is applied per spouse.
The short-term rental position
Not a "rental activity" under the regs
Material participation: 100 hrs & more than anyone else, or 500 hrs
An STR with a short average stay is not a rental activity for §469 purposes — so it isn't automatically passive. Materially participate and the loss is non-passive, with no REPS required.
Both of the real doors turn on hours, and the hours have to be contemporaneous. Courts routinely throw out logs reconstructed after the fact. We set the log up before the property is placed in service and review it at each projection meeting — not in March.
Depreciation is a loan, not a gift
Every dollar deducted lowers your basis. At sale, that difference comes back as recapture — at rates that are not the 15% or 20% most sellers are expecting.
Straight-line depreciation on the building is recaptured as unrecaptured §1250 gain, taxed at up to 25%. Accelerated depreciation on the components a cost segregation study carved out is §1245 property, recaptured at ordinary income rates — up to 37%. Above the income thresholds, add 3.8% net investment income tax on top of either.
None of this makes accelerated depreciation a bad idea. A deduction against 37% income today, repaid at 25% in a decade, is still arbitrage — and the time value of the deferral is real. But the sequence has to be planned. A §1031 exchange defers the whole gain, including recapture, with a 45-day identification window and a 180-day close. A sale in a low-income year, an installment sale, or pairing the sale with harvested losses each change the result.
After-tax proceeds under three exit paths — outright sale, §1031, and hold — so the decision is made on the number you'll actually keep.
The rental property timeline
The tax result of a rental is decided at five moments. Most of them come before anyone thinks to call a tax advisor.
- Before closing
Structure the purchase
Which spouse will materially participate. Whether a short-term rental strategy is realistic for the market and the property. Title, entity, and financing structure. Whether a cost segregation study will produce a usable loss — and if not, whether to skip it.
- Placed in service
Start the clocks
Depreciation begins when the property is ready and available to rent — not when the first guest arrives. The cost segregation study is commissioned. The hours log starts the same day.
TrapA property placed in service on January 3 instead of December 28 moves the entire first-year deduction into the next tax year. - During the year
Log hours, track average stay
Contemporaneous time records with dates, tasks, and durations. For STRs, running average-stay math so a few long bookings don't push the average past seven days. Improvements vs. repairs classified as they happen.
- By December 31
Confirm the tests are met
The 100- or 500-hour threshold, the 750-hour REPS test, improvements placed in service, the grouping or aggregation election decided for the return. The projection meeting is where a shortfall gets fixed while there is still time.
- At sale
Sequence the exit
Recapture computed before the listing. §1031 identification and exchange timelines mapped against the closing. Suspended passive losses released in the year of a full disposition — often the largest single item on the return.
Own a rental, or about to?
Bring the closing statement, the depreciation schedule from your last return, and a rough idea of your hours. We'll tell you which door you're standing in front of.