Real Estate Tax Planning for Investors and Homeowners

Real estate ownership involves a series of financial decisions, and understanding the tax implications of these choices is part of the process. From purchase to sale, strategic planning can influence the amount of tax owed. The tax code has different rules for a primary home versus an investment property, and navigating them can affect financial outcomes.

Tax Planning for Your Primary Residence

Homeowners who itemize deductions can often deduct mortgage interest paid on their primary residence. This deduction applies to interest on debt used to buy, build, or improve the home. For mortgage debt incurred after December 15, 2017, the deduction is limited to the interest on up to $750,000 of indebtedness.

Another available deduction is for state and local taxes (SALT), which includes property taxes. The total amount a taxpayer can deduct for all state and local taxes combined is capped at $10,000 per household per year.

The tax code provides a benefit when selling a primary residence under Internal Revenue Code Section 121. A single individual can exclude up to $250,000 of capital gain from the sale, and this amount doubles to $500,000 for a married couple filing jointly. If the profit is below these thresholds, the homeowner may owe no federal income tax on it.

To qualify for this home sale exclusion, the taxpayer must meet both an ownership and a use test. The ownership test requires owning the home for at least two of the five years before the sale. The use test requires living in the home as a primary residence for at least two of the five years before the sale.

Calculating the capital gain starts with the property’s tax basis, which is the purchase price plus certain closing costs. This initial basis is then increased by the cost of capital improvements to create an “adjusted basis.” A capital improvement adds value to the home or prolongs its life, such as adding a new room or replacing a roof. This is distinct from a routine repair, like painting a room or fixing a leaky faucet, whose cost cannot be added to the basis. The capital gain is the final sale price, less selling expenses, minus this adjusted basis.

Tax Planning for Rental and Investment Properties

For real estate held for rental or investment purposes, all rental income is taxable and must be reported. Property owners can offset this income by deducting ordinary and necessary expenses, including mortgage interest, property taxes, insurance, and property management fees. The costs of maintenance and repairs are also deductible in the year they are paid.

Depreciation is a non-cash deduction that allows an owner to recover the cost of the property over a set period. The building itself is depreciable, but the land it sits on is not. For residential rental properties, the IRS has determined a useful life of 27.5 years, over which the owner deducts a portion of the property’s cost basis annually.

The ability to deduct losses from rental activities is often limited by the passive activity loss (PAL) rules. These rules prevent taxpayers from deducting losses from passive activities, like most rental real estate, against non-passive income such as wages. The losses are instead suspended and carried forward to offset passive income in future years.

An exception to the PAL rules exists for some taxpayers. Individuals who are “active participants” in their rental activity may be able to deduct up to $25,000 in rental losses against other income. This special allowance is subject to income limitations; it begins to phase out for taxpayers with a modified adjusted gross income over $100,000 and is completely unavailable for those with an income of $150,000 or more.

When an investment property is sold, the gain is calculated by subtracting the adjusted basis from the sale price. A unique factor is “depreciation recapture,” as all depreciation deductions taken reduce the property’s basis and increase the total gain. The portion of the gain from these depreciation deductions is taxed at a maximum rate of 25 percent.

Advanced Tax Deferral and Reduction Strategies

Investors can use several strategies to manage tax liabilities, including a like-kind exchange under Internal Revenue Code Section 1031. This provision allows an investor to defer paying capital gains tax on the sale of an investment property by reinvesting the proceeds into a new, “like-kind” property. This strategy is exclusively for investment or business-use properties.

The rules for a 1031 exchange are time-sensitive. From the date the original property is sold, the investor has 45 days to identify potential replacement properties. The investor then has a total of 180 days from the initial sale to close on the purchase of one or more of the identified properties. The full amount of the sale proceeds must be reinvested to completely defer the capital gains tax.

A cost segregation study is a strategy to accelerate depreciation deductions. An engineering-based analysis identifies specific components within a building, such as carpeting or specialty lighting, that have shorter useful lives under the tax code. These components can then be depreciated over faster periods, often 5, 7, or 15 years. This does not change the total amount of depreciation that can be taken, but it accelerates when those deductions can be claimed, improving near-term cash flow.

Qualifying for “real estate professional” status with the IRS can provide a tax advantage. To meet the qualifications, a taxpayer must spend more than half of their personal service time in real property trades or businesses and perform more than 750 hours of service in those activities during the year. The primary benefit is an exemption from the passive activity loss rules for rental activities, allowing these losses to be deducted against all other forms of income.

Estate and Gift Planning with Real Estate

The method by which real estate is transferred to the next generation has tax consequences for the recipient. In 2025, an individual can gift up to $19,000 to any number of people without filing a gift tax return. This amount is known as the annual gift tax exclusion.

When real estate is given as a gift, the recipient also receives the giver’s original tax basis, which is known as a “carryover basis.” For example, if a parent purchased a property for $100,000 and gifts it to a child when it is worth $1 million, the child’s basis is the original $100,000. This creates a large potential capital gain for the child upon a future sale.

A different rule applies to inherited property under Internal Revenue Code Section 1014. When an individual inherits real estate, the property’s tax basis is “stepped-up” to its fair market value on the date of the original owner’s death. This step-up in basis can result in a tax benefit for the heir.

Using the same scenario, if the child inherits the property worth $1 million at the time of the parent’s death, their basis becomes $1 million. If the child then sells the property for that same market value, there would be little to no capital gain to tax. This provision effectively erases the capital gains tax liability that accumulated during the deceased owner’s lifetime.