Real estate investment is one of the more common—and arguably more consistent—avenues to wealth creation, delivering capital appreciation, rental income, and portfolio diversification. While the appeal of real estate may be evident, complex federal, state, and local tax regulations can present a major challenge to the profitability of your property investments.
In this article, we’ll examine the tax-efficient strategies that lie at the heart of successful real estate investment, the deductions, credits, and deferral mechanisms available, and how tax advisory platforms like Harness can help you maximize your returns.
Table of Contents
Understanding real estate taxes
The taxes associated with owning, operating, and ultimately selling real estate can significantly impact your overall financial performance, and it’s important to familiarize yourself with several core tax types.
- Income tax on rental profits: Net rental income is taxed at ordinary federal income tax rates (10% to 37% for 2025). State income taxes also apply, varying by jurisdiction.
- Property taxes: These local taxes are based on assessed property value and are generally deductible, though federal limitations may apply to total state and local tax (SALT) deductions.
- Capital gains tax: Profits from selling property are subject to capital gains tax. Short-term gains (on assets held for less than 1 year) are taxed as ordinary income. Long-term gains (on assets held for over 1 year) benefit from lower federal rates (0%, 15%, or 20% for 2025). Importantly, depreciation previously claimed on a property is “recaptured” by the IRS at a maximum federal rate of 25% upon sale.
- Net Investment Income Tax (NIIT): A 3.8% tax on net investment income, including passive rental income and capital gains, applies to higher-income taxpayers (Modified Adjusted Gross Income exceeding $200,000 for single filers, $250,000 for married filing jointly in 2025).
- State-specific & transfer taxes: Beyond federal taxes, states may impose their own income taxes on rental profits and capital gains. Additionally, many states and localities charge “real estate transfer taxes” (deed/stamp taxes) on property sales, varying widely and typically paid by buyer, seller, or split.
What are the most tax-efficient ownership structures?
The entity you choose to hold your real estate investments can profoundly impact your personal liability, available deductions, and exit strategies. The most common ownership structures are as follows:
Direct ownership (sole proprietorship): This form of ownership is perhaps the simplest for individuals and involves reporting income on Schedule E. That said, it offers no personal liability protection, and passive activity loss (PAL) rules often limit the ability to deduct losses against active income.
Limited Liability Company (LLC): One of the more popular ownership structures, LLCs offer personal liability protection. Single-member LLCs are taxed as sole proprietorships, while multi-member LLCs are partnerships.
S-corporation: An S-corporation election offers pass-through taxation, meaning the LLC itself avoids federal income tax. Instead, profits and losses are taxed once on the owners’ personal returns at their individual rates. This structure allows real estate investors to pay themselves a “reasonable salary” (subject to payroll taxes) and take remaining profits as non-self-employment-taxed distributions, potentially reducing the overall tax burden. It should be noted, however, that S-corporations involve more administrative compliance and have shareholder limitations.
Partnership: Ideal for co-ownership, partnerships offer pass-through taxation where income and losses flow to partners’ individual returns. General partnerships lack liability protection, however, while limited partnerships provide it for passive partners.
Real Estate Investment Trust (REIT): This ownership structure is primarily for larger, often publicly traded portfolios. REITs generally avoid corporate income tax by distributing at least 90% of taxable income to shareholders, offering a way for individuals to invest in large-scale real estate with dividends. However, they actually pay dividends out of funds from operations, so cash flow has to be strong or the REIT must either dip into reserves, borrow to pay dividends, or distribute them in stock (which causes dilution).
What are the key tax strategies during real estate ownership?
Once an investment property is acquired, a number of ongoing tax strategies can be used to reduce taxable income and improve cash flow.
Depreciation
Depreciation is a highly effective non-cash deduction that allows businesses and investors to recover the cost of tangible assets that lose value over time due to wear and tear, obsolescence, or deterioration.
Standard depreciation schedules: For tax purposes, residential rental properties are typically depreciated using the straight-line method over 27.5 years, while non-residential (commercial) properties are depreciated over 39 years. It’s important to remember that land itself is not considered a depreciable asset, so the purchase price must be appropriately allocated between the land and the depreciable building structure.
Accelerated deductions (cost segregation): A cost segregation study reclassifies certain property components (e.g., carpeting, wiring) into shorter recovery periods (5, 7, or 15 years), accelerating deductions and improving cash flow.
Bonus depreciation: This allows immediate deduction of a percentage of eligible new or used property costs (for 2025, it’s 40%). Investors should be aware that legislative proposals are under consideration to restore 100% bonus depreciation for assets placed in service on or after January 2025, and this should be monitored carefully.
Section 179 expensing: A provision that permits immediate deduction of qualifying equipment and software up to a limit. For 2025, the maximum deduction is $1,250,000, phasing out if purchases exceed $3,130,000. Certain real property improvements may also qualify.
Comprehensive deductible expenses
Beyond depreciation, investors can deduct a wide range of ordinary and necessary expenses incurred in operating their rental properties. Common deductible expenses include:
Operating expenses: Includes mortgage interest, property taxes, insurance, utilities, advertising, management fees, and professional services.
Repairs vs. improvements: Only repairs (maintaining current condition) are immediately deductible. Improvements (adding value or prolonging life) are capitalized and depreciated.
Home office and reasonable travel expenses related to rental activities can also be deductible. Whatever deduction you pursue, meticulous record-keeping is vital for substantiating them to the IRS.
Passive Activity Loss rules
The Passive Activity Loss (PAL) rules are among the most important tax considerations for real estate investors. Under these rules, rental activities are generally considered “passive activities” by the IRS. This designation means passive losses can generally only be used to offset passive income, not active income (like wages, salaries, or active business income). Unused passive losses are “suspended” and carried forward to future years until passive income is generated or the activity is fully disposed of.
There are, however, a number of exceptions to PAL rules:
Active participation exception: Individuals “actively participating” in rental real estate can deduct up to $25,000 of passive losses against non-passive income. This deduction phases out for Modified Adjusted Gross Income (MAGI) between $100,000 and $150,000.
Real Estate Professional Status (REPS): Qualifying for REPS allows rental activities to be treated as non-passive, enabling unlimited loss deductions. To qualify, you must:
- Perform over half your total annual services in real property trades or businesses where you materially participate.
- Perform over 750 hours of service annually in real property trades or businesses where you materially participate.
The IRS strictly scrutinizes REPS claims, so careful record-keeping is again essential.
Qualified Business Income (QBI) Deduction (Section 199A)
This deduction allows eligible self-employed individuals and pass-through entity owners to deduct up to 20% of their Qualified Business Income, including from rental real estate, subject to certain criteria being met.
Eligibility: Rental real estate can qualify as a “trade or business” for QBI purposes if the activity is regular and continuous. The IRS provides a safe harbor for rental real estate enterprises, requiring a minimum of 250 hours of rental services annually, along with separate books and records.
Limitations: The QBI deduction is subject to taxable income thresholds (for 2025, $197,300 for single filers; $394,600 for married filing jointly), with higher income potentially triggering W-2 wage or unadjusted property basis limitations.
Future of QBI: QBI is currently scheduled to expire at the end of 2025. However, legislative efforts are ongoing to make it permanent and potentially increase the deduction percentage from 20% to 23% from 2026.
What are tax-efficient real estate exit strategies?
The culmination of a successful real estate investment often involves its sale, which can trigger major tax liabilities. Effective exit planning offers the opportunity to potentially defer or even eliminate capital gains taxes.
The 1031 Exchange (Like-kind exchange)
Section 1031 of the Internal Revenue Code is an effective tool to defer capital gains taxes when selling an investment property by reinvesting the proceeds into another “like-kind” property. In essence, the tax basis of the sold property is transferred to the new one, deferring capital gains tax until the replacement property is eventually sold without another exchange.
When it comes to 1031 exchanges, there are several key rules investors need to be aware of:
“Like-Kind” property: This means that the properties must be of the same nature or character, regardless of their grade or quality. Importantly, it doesn’t mean “same type” (e.g., you don’t have to exchange an apartment building for another apartment building). 1031 exchanges are allowed as long as both properties are held for productive use in a trade or business or for investment, and are located within the United States.
45-Day Identification Period: From the sale closing date, you have 45 calendar days to identify potential replacement properties in writing.
180-Day Exchange Period: You must acquire the identified property within 180 calendar days of the relinquished property’s sale, or by your tax return due date (including extensions), whichever is earlier.
Qualified Intermediary (QI): An independent QI must hold the sale proceeds to prevent “constructive receipt,” which would trigger immediate taxation.
If, as part of the exchange, you receive cash or non-like-kind property (known as “boot”), that portion will be taxable to the extent of your realized gain. The goal of a fully tax-deferred exchange is to acquire a replacement property of equal or greater value, with equal or greater debt, and reinvest all cash proceeds.
Qualified Opportunity Zones (QOZs)
The Opportunity Zones program encourages long-term investments in distressed U.S. communities by offering tax benefits for reinvesting eligible capital gains into Qualified Opportunity Funds (QOFs). The program offers real estate investors a number of tax benefits:
Deferral of capital gains: Gains invested in a QOF within 180 days are deferred until the QOF investment is sold or exchanged, or December 31, 2026, whichever is earlier.
Basis step-up: The deferred gain’s basis increases by 10% after 5 years, and an additional 5% after 7 years (total 15%), reducing the eventually recognized gain.
Tax-free growth: If the QOF investment is held for at least 10 years, any appreciation on that investment is entirely tax-free upon sale.
While the current QOZ program concludes on December 31, 2026, proposals are active in Congress to extend the program, potentially with new zone designations starting in 2027.
Installment sales
Beyond a full cash sale or an exchange, investors can also defer capital gains through an installment sale. This approach allows you to spread out the recognition of your taxable profit over multiple years by receiving payments for your property over an extended period, rather than upfront.
The primary benefit lies in potentially avoiding a higher tax bracket that a large, one-time gain might trigger, reducing your overall tax liability by keeping annual taxable income lower. Investors report a portion of the gain as income each year based on a “gross profit ratio,” while any interest on the unpaid balance is taxed as ordinary income. A key consideration, however, is that depreciation recapture, unlike the rest of the capital gain, is generally taxed in full in the year of the sale, even with an installment arrangement.
Charitable Remainder Trusts (CRTs)
For investors with highly appreciated properties and philanthropic goals, a CRT provides an advanced tax planning solution. The process involves an investor transferring appreciated real estate into an irrevocable CRT, which then sells the asset tax-free. The trust provides an income stream to the investor (or other beneficiaries) for a term or life, with remaining assets going to charity. This allows for the tax-free sale of appreciated property, offers a potential immediate income tax deduction, and removes the asset from an investor’s taxable estate.
The need for expert tax advice – how Harness can help
Given the number of deductions and provisions available—and their associated eligibility requirements—creating a tax-efficient real estate investment strategy can be a complex process. Gaining professional tax advice is therefore highly recommended.
At Harness, we specialize in connecting businesses and individuals with the precise tax expertise they need. Our tax advisors tailor highly personalized strategies based on specific circumstances, helping real estate investors, among others, make the most of their portfolios. With a tax advisor from Harness in your corner, we strive to help you reduce your tax burden and aim to improve your profitability, diligently and compliantly.
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FAQs
Common questions regarding real estate taxation include:
What is depreciation recapture and how does it affect my real estate sale?
Depreciation recapture occurs when you sell an income-producing property for a gain after claiming depreciation deductions. These previously claimed deductions, which reduced your taxable income during ownership, are “recaptured” by the IRS. For real estate, this portion of your gain is taxed at a maximum federal rate of 25% (for Section 1250 property), before the standard long-term capital gains rates apply to any remaining profit.
What are the most important deadlines to remember for a 1031 Exchange?
A 1031 exchange has two strict deadlines. First, you have 45 calendar days from the closing date of your relinquished property to formally identify potential replacement properties. Second, you must acquire and close on the identified replacement property within 180 calendar days from the relinquished property’s closing date, or by your tax return due date (including extensions), whichever is earlier. Missing either deadline invalidates the exchange, making the deferred gain immediately taxable.
How difficult is it to qualify as a Real Estate Professional (REPS) for tax purposes?
Qualifying REPS can be challenging due to stringent IRS requirements. You must meet two annual tests: performing over half your total annual services in real property trades or businesses where you materially participate, AND accumulating over 750 hours of service in those same activities. The IRS heavily scrutinizes REPS claims, making contemporaneous record-keeping of your hours and activities essential to substantiate your status.
Which ownership structure is generally best for a new real estate investor?
While there’s no universal “best” ownership structure. LLCs are extremely popular for their personal liability protection and tax flexibility (they can be taxed as a sole proprietorship, partnership, S-Corp, or C-Corp). Always consult a qualified tax professional to determine the optimal structure for your specific circumstances.
How do I stay updated on the latest tax law changes affecting real estate?
The most reliable approach is to maintain regular communication with a dedicated tax professional (CPA or tax attorney) who specializes in real estate. They continuously monitor legislative developments and can advise on their specific implications for your investments. Additionally, subscribing to reputable tax news sources, reviewing IRS publications, and attending industry-specific webinars can help keep you abreast of relevant changes.
Disclaimer:
Tax related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC (“Harness Tax”).
Content should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Material presented is believed to be from reliable sources, however, we make no representations as to its accuracy or completeness.
All investments and investment strategies have the potential for profit or loss. There can be no guarantee that investment goals will be achieved, and there can be no assurance that any specific investment or strategy will be profitable. Different types of investments involve varying degrees of risk. Past performance may not be indicative of future results.
Risks of Investing in Real Estate: Real estate is increasingly being used as part of a long-term core strategy due to increased market efficiency and increasing concerns about the future long-term variability of stock and bond returns. In fact, real estate is known for its ability to serve as a portfolio diversifier and inflation hedge. However, the asset class still bears a considerable amount of market risk. Real estate has shown itself to be very cyclical, somewhat mirroring the ups and downs of the overall economy. In addition to employment and demographic changes, real estate is also influenced by changes in interest rates and the credit markets, which affect the demand and supply of capital and thus real estate values. Along with changes in market fundamentals, investors wishing to add real estate as part of their core investment portfolios need to look for property concentrations by area or by property type. Because property returns are directly affected by local market basics, real estate portfolios that are too heavily concentrated in one area or property type can lose their risk mitigation attributes and bear additional risk by being too influenced by local or sector market changes.
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