The Tax Layer

The tax story starts at purchase and follows the property all the way through the sale. How the price is allocated shapes depreciation from the beginning, while repairs and improvements follow different rules as you go. Losses may be usable now or carried forward, and the depreciation taken during ownership matters again when the property is sold.

This chapter follows that sequence, narrowing each rule to the decision in front of you. The tax answer belongs with your CPA. Here, the focus stays on what those rules mean in practice, including when taxable income and actual cash flow stop moving together.

Why this chapter is written as questions

A tax rule can be perfectly clear and still leave your own tax outcome uncertain. The same duplex can be taxed differently depending on the owner's income, filing status, and level of participation. The rules in this chapter are based on current IRS guidance, but they stop short of telling you what they mean for your return.

The rest belongs with your CPA. Each section gives you enough of the rule to understand what matters. Then bring the numbers you've worked through and your questions to someone who can see the whole return.

Ask your CPA: How do my income, filing status, and involvement in property operations affect how rental tax rules apply to me?

The depreciation baseline

A residential rental building is generally depreciated over 27.5 years, but the land it sits on does not qualify for depreciation. The purchase price is split between the land and building,¹ and that split sets the annual deduction. From there, depreciation follows the 27.5-year tax schedule whether or not the building loses value.

Depreciation can reduce taxable rental income without changing the rent collected or your mortgage payment. The divergence, revisited, later in this chapter, shows what that difference looks like in actual numbers. The starting point is to determine how much of the purchase price belongs to the building and how much belongs to the land. The split needs to be based on something concrete, usually the county assessment ratio or an appraisal.

Ask your CPA: How should I allocate the purchase price between land and improvements, and what should I use to support it?

Bonus depreciation and cost segregation

Bonus depreciation is back at 100%, and this time it's permanent. Under the 2025 federal tax law, qualified property acquired and placed in service after January 19, 2025 can once again be fully deducted in the first year. It also ended the scheduled reductions in bonus depreciation. For bonus depreciation, the acquisition date is based on when the binding contract was signed, not when the deal closed.²

With the building on a 27.5-year depreciation schedule, bonus depreciation is limited to qualifying shorter-life components inside and around it. Those can include appliances, carpet, cabinetry, and certain land improvements. A cost segregation study identifies those components, assigns values to them, and separates them from the building for depreciation purposes.

Whether the study is worth the fee depends on the property and on your tax situation. On a smaller purchase, the tax savings may not be enough to make the study worthwhile. On a larger property, the numbers may support it. The deduction also has to be usable. The passive-loss rules in the next section determine whether you can use the deduction on this year's return or if it needs to be saved for a later year.

Ask your CPA: Would a cost segregation study be worthwhile at this purchase price? How would bonus depreciation affect my taxes this year?

Passive loss limits

A rental can generate positive cash flow and still show a loss on your tax return. Deductible expenses, including depreciation, can exceed the rental income reported for the year.

Rental losses are generally considered passive. In most cases, they offset passive income rather than wages or other earnings. There are two common situations where those losses can be used more broadly.³

The first is the special allowance for active participation. If you are involved in the property's management decisions, you may be able to use up to $25,000 of rental losses against other income. The allowance begins to phase out once modified adjusted gross income reaches $100,000 and disappears at $150,000. Different limits apply to married taxpayers filing separately.

The second is real estate professional status, which has a much higher threshold. You generally need to spend more than 750 hours a year working in real estate businesses you are personally involved in, with that work making up more than half of your total working time.

If the loss isn't usable this year, it doesn't disappear. It stays available, often to offset passive income in another year or when the property is sold. A large deduction on paper isn't always one you can use right away.

Ask your CPA: Can I use this year's rental losses against my other income? If not, when can they be used? Is there anything about my tax situation that changes the answer?

Repair or improvement

A repair and an improvement can lead to completely different tax treatment, even when the work involves the same part of the property. Repairs are deducted in the year you pay for them, while improvements are spread out through depreciation. What separates the two is the scope of the work.

The IRS treats a project as an improvement when it materially improves the property, restores a major part of it, or adapts it to a new use.⁴ Routine upkeep that keeps the property in ordinary working condition is treated as a repair.

A roof is a good example. Patching a damaged section and replacing a few shingles keeps the existing roof in service and is treated as a repair. Replacing the entire roof restores a major part of the property, so the cost is treated as an improvement and depreciated over time. The project may involve the same roof, but the scope changes the tax treatment.

Three safe harbors allow certain expenses to be deducted right away.

1. The de minimis safe harbor can apply to items costing $2,500 or less per invoice.
2. The routine-maintenance safe harbor covers recurring upkeep needed for the property to continue operating as expected.
3. The small-taxpayer safe harbor can apply to buildings with a basis of $1 million or less.

For qualifying owners, the annual limit under the small-taxpayer safe harbor is 2% of the building's basis or $10,000, whichever is lower.

Ask your CPA: How should I treat this specific work for tax purposes? Do any of these safe harbors apply?

The divergence, revisited

Depreciation does not pay the mortgage. Even a substantial tax benefit will not rescue a property with weak cash flow.

The duplex from Chapter 5, Close and the First 90 Days, shows both sides in its first full year. The example is illustrative and assumes 20% of the $265,000 purchase price is assigned to land. Reserve funds are treated as property expenses so the same costs are reflected on both sides.

Year one	What the bank account sees	What the tax return sees
Gross rent	$31,200	$31,200
Operating expenses	$11,296	$11,296
Mortgage interest	Paid as part of the mortgage	$14,844 deduction
Mortgage principal	$1,832 paid	Not deductible
Depreciation	No cash leaves the account	$7,709 deduction
Result	$3,228 in the account	-$2,649 taxable result

The bank account gained $3,228. The tax return shows a $2,649 loss. Both are true, and the difference comes from two places: depreciation creates a deduction without moving cash, while principal uses cash without creating one.

Read the two columns together. In a flat-rent market, cash flow can still tighten despite the benefit those deductions may bring at tax time. Chapter 1, The Market Read, follows that pressure from the market side, while Chapter 6, Operating in a Flat-Rent Market, deals with it once you own the property.

A favorable tax benefit can make weak cash flow easier to miss. Run the duplex yourself, and keep the tax result beside the cash flow before deciding what the property can actually carry. A property can produce an attractive deduction and still come up short when the mortgage is due.

Ask your CPA: Given my other income, how would this property affect my taxes this year? Would the tax impact be different if the property had negative cash flow?

Exit taxes, previewed

Depreciation lowers your taxable income while you own the property, but it also lowers your tax basis. When you sell, that reduction can leave you with a larger taxable gain. The portion tied to prior depreciation can be taxed at a federal rate of up to 25%.⁵ The benefit is real while you own the property, but the tradeoff comes with the sale.

A Section 1031 exchange can defer that tax if you move from one qualifying investment property into another. The gain, including the portion tied to depreciation, stays deferred as long as the exchange follows the required timing and identification rules.⁶ The site's 1031 exchange guide covers the mechanics, with a companion guide on financing the replacement property. Chapter 9, Portfolio and Exit, takes up the larger strategy. Ownership structure matters too, since an LLC or multiple owners can change how the exchange needs to be handled.

Ask your CPA: If I sell this property, how will depreciation recapture affect what I keep after taxes? Would a 1031 exchange make sense for my exit?

Records that survive scrutiny

Tax time is much easier when the paper trail stays current throughout the year. The lease file from Chapter 5, Close and the First 90 Days is where the recordkeeping begins. From there, build out the tax file with the documents that matter:

• Keep the closing statement along with the support for how the purchase price was divided between land and improvements.
• Save every invoice, with the repair-or-improvement decision noted while the details are still fresh.
• If you are anywhere near the real estate professional requirements, keep an hours log.
• Update the depreciation schedule each year, since it will matter when the property is sold.
• Keep the reserve account statements too, so the tax return can always be traced back to what actually happened in the bank account.

Chapter 3, Underwriting the Expense Stack, priced the costs. The tax file documents what you actually spent. A complete picture gives your CPA more room to spot every deduction or tax benefit that could work in your favor.

Ask your CPA: What records should I send you each quarter, and how should they be organized?

The two questions every chapter answers still apply here. On the ratio: tax deductions do not change the lender's DSCR calculation. On cash flow: the tax benefit may show up once a year, but the mortgage is due monthly. Keeping those two realities separate keeps a tax benefit from being mistaken for operating cash flow.

Numbers above are illustrative scenarios computed by our calculators from the stated inputs. They are not offers, quotes, or records of transactions. OneMoreDoor Capital arranges business-purpose financing for non-owner-occupied investment property through its lending partners. Nothing in this chapter is tax advice; consult your CPA about your own return.

Footnotes

1. IRS Publication 527, Residential Rental Property: residential rental property is depreciated over 27.5 years; land is not depreciable, and the basis is allocated between land and improvements. ↩

2. IRS Notice 2026-11, interim guidance implementing Public Law 119-21: 100% additional first-year depreciation is permanent for qualified property acquired and placed in service after January 19, 2025, with acquisition determined under the binding written contract rules; a transition election to the prior 40% rate applies for the first tax year ending after that date. ↩

3. IRS Publication 925 (2025), Passive Activity and At-Risk Rules: the $25,000 special allowance for active participation in rental real estate, reduced by 50% of modified adjusted gross income over $100,000 and eliminated at $150,000 ($12,500 and lower thresholds for married individuals filing separately); real estate professional tests of more than 750 hours and more than half of personal services; disallowed losses carried forward. ↩

4. IRS, Tangible Property Final Regulations: improvements defined by betterment, restoration, or adaptation; de minimis safe harbor of $2,500 per item or invoice without an applicable financial statement ($5,000 with one), elected annually; routine maintenance safe harbor; safe harbor for small taxpayers at the lesser of 2% of unadjusted basis or $10,000 for buildings with an unadjusted basis of $1 million or less. ↩

5. IRS Topic No. 409 and Publication 544: unrecaptured section 1250 gain, the portion of gain attributable to prior depreciation on real property, taxed at a maximum rate of 25%. ↩

6. IRS, Like-Kind Exchanges, Real Estate Tax Tips: section 1031 defers gain on the exchange of real property held for business or investment, subject to identification and exchange-period deadlines. ↩