CHAPTER 10
Real Estate
The vast majority of Americans own real estate, with 65.8% owning their own homes as of the second quarter of 2022. (Tax write‐offs for your main home are discussed in Chapter 4.) But owning a principal residence isn't the only way to invest in real estate. Many individuals also own second homes or invest in rental properties to generate income. These investments produce important tax breaks. If real estate activities are your business, see Chapter 14.
This chapter covers tax breaks related to real estate other than your principal residence. For more information, see IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes); IRS Publication 587, Business Use of Your Home (Including Use by Day‐Care Providers); and IRS Publication 946, How to Depreciate Property.
Vacation Home
The rich have traditionally maintained more than one residence, summering in Newport, skiing in Aspen, escaping winters in Palm Beach. But today, second homes aren't limited to the very rich; they are increasingly common among an ever‐broadening populace. The tax law offers some tax breaks that help to make ownership of vacation homes more affordable.
Benefit 
If you use your vacation home solely for your own personal enjoyment (you don't rent it out at any time during the year), you can deduct all of your real estate taxes and home mortgage interest (if the vacation home is designated as your second home under the home mortgage interest rules in Chapter 4). But, like your personal residence, you can't write off any of the costs of utilities, insurance, or upkeep.
If you rent out a home that you use for part of the year yourself, you may be entitled to certain tax benefits over and above those allowed for pure personal use of the home. The rules that apply to you depend on your rental period and the time that you use the home.
Conditions for Vacation Home with No Rentals
The conditions for deducting real estate taxes and home mortgage interest are explained in Chapter 4.
Conditions for Vacation Home with Rentals
The conditions you must meet and the benefits you are entitled to depend on how long you rent out the home and how long you use it for yourself during the year. There are 3 categories into which you can fall.
- Rental of no more than 14 days during the year.
- Rental of 15 days or more but personal use is for less than 14 days or 10% of the days of rental.
- Personal use is more than 14 days or 10% of the total days the home was rented for a fair rental price.
TAX‐FREE RENTAL INCOME
If you rent out your home for no more than 14 days during the year, you do not have to report the rental income. There's no dollar limit on this exclusion.
You cannot, however, deduct any expenses related to maintaining the home, depreciation, or any rent you pay. Of course, if you itemize your deductions, you can deduct your mortgage interest, if you designate the home as your second residence, and your real estate taxes (there is no limit on the number of homes for which you can deduct real estate taxes).
BUSINESS DEDUCTIONS
If you rent out your home for 15 days or more but you personally use the home for less than 14 days or 10% of the days of rental, your rental activities are viewed as a business.
As such, you must report all of the rental income, but you can deduct from rental income only the mortgage interest, real estate taxes, operating expenses, and depreciation prorated for rental use. If your prorated expenses, including depreciation on a home you own, exceed your rents for the year, you can use the loss to offset your income from other purposes (subject to the passive loss limitations discussed further on).
Personal use of your home includes any day the home is used by:
- You or any member of your family (unless a family member pays a fair rental price)
- Anyone else who pays less than a fair rental price
- Anyone under a reciprocal agreement who lets you use his or her home
- Any other person who owns a part of the home (unless it is rented to that person under a shared equity agreement)
You do not have to count your personal use during the year if your home is rented for at least 12 consecutive months.
However, your actual write‐offs for the year may be limited by the passive activity loss rules discussed later.
LIMITED BUSINESS DEDUCTIONS
If your personal use is more than 14 days or 10% of the total days the home was rented for a fair rental price, you must report all of the rental income. Your deductions are limited to the amount of rents you receive. And the order in which you claim your deductions is carefully orchestrated:
- Mortgage interest, real estate taxes, and casualty losses are fully deductible. You can claim them even if they exceed your rental income. But you must apply them first against your rental income to determine how much of your other deductions to claim.
- Operating expenses, such as utilities and maintenance costs, are deductible only to the extent of your rental income after reduction for mortgage interest and so on.
- Depreciation and other basis adjustments are deductible only to the extent that rental income has not yet been fully offset by the aforementioned deductions.
PASSIVE LOSS LIMITATIONS
If the rental of your vacation home is treated as a rental activity (your personal use is fewer than 15 days but the rental period is more than 2 weeks), you are subject to the passive loss rules. Generally, your deductions related to the rental of your home cannot exceed all of your passive activity income from the year (income from this rental activity plus any other passive activities). (The law calls them passive “losses” but really means deductions in excess of rental income.)
Passive activity losses in excess of passive activity income can be carried forward and used in a future year when there is passive activity income to offset it. There is no limit on the carryforward period.
There are 3 key exceptions to the ban on deducting passive losses in excess of passive activity income.
- You can deduct all carryover losses from a passive activity in the year in which you dispose of your passive activity (e.g., sell your vacation home).
- You can deduct up to $25,000 of passive activity losses in excess of passive activity income from a rental activity in which you actively participate (e.g., approve new tenants, decide on rental terms, and authorize capital expenditures and repairs). The $25,000 limit is phased out when your modified adjusted gross income exceeds $100,000 and is completely phased out when MAGI reaches $150,000. MAGI for this purpose means AGI without taxable Social Security benefits, the exclusion for interest from U.S. savings bonds used for higher education, the exclusion for employer‐paid adoption expenses, and the deductions for IRA contributions and student loan interest. If you're married, filing a separate return, and lived apart from your spouse for the entire tax year, the special allowance is up to $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you can't use the special allowance.
- You are a “real estate professional” who meets certain tests in the tax law. In this case, your losses from rental realty are not subject to the passive activity loss rules. This is explained in greater detail later in this chapter under “Rentals.”
Planning Tip
If you rent out your vacation home for more than 15 days and use it for less than 14 days or 10% of the days of rental, you are not subject to the passive activity loss limitations on your deductions if you are considered a “real estate professional.” This means:
- More than 50% of your personal services during the year are performed in real estate trades or businesses in which you materially participate (e.g., work more than 500 hours for the year, which is 10 hours a week for 50 weeks, or your participation is substantially all of the participation for the activity during the year and this is more than the time you spend in a job or on a non‐real estate business).
- You perform more than 750 hours of service in real estate trades or businesses in which you materially participate.
Pitfalls
Getting help with home renovations through an HGTV show may be taxable even if the show uses the home for fewer than 15 days. The value of the home improvements is not tax‐free rental, but rather taxable income.
If you rent out your home for more than 15 days but use it for less than 14 days or 10% of the rental days, you cannot deduct the portion of home mortgage interest disallowed under the rental loss rules discussed earlier. In this case, since your home ceases to be treated as a personal residence, you cannot itemize any portion of the mortgage interest.
When you sell your vacation home, don't be surprised by the tax impact that can result. Your gain probably does not qualify for the home sale exclusion (see Chapter 4) because the vacation home is not your principal residence. As long as you own the home for more than one year, your gain is a long‐term capital gain.
However, if you rented the home at any time and claimed depreciation on it, you must recapture the depreciation on the sale. This means that gain to the extent of your depreciation is taxed at 25% (assuming you are in a tax bracket at or above this rate).
If you realize a loss on the sale of your vacation home, your ability to claim the loss depends on whether or not the home was used for rental.
- If the home was used solely for personal purposes, no loss can be claimed on the sale.
- If the home was used some of the time for rental activities, you cannot claim a loss on the sale.
- If the home was converted solely to rental, you can then claim a capital loss on the sale. The loss is limited to the decline in value after the conversion.
Where to Claim the Benefit
If you use your vacation home solely for personal purposes, you deduct your mortgage interest and real estate taxes on Schedule A of Form 1040 or 1040‐SR (as explained in Chapter 4).
If you rent out your vacation home, you report your rents and expenses in Part I of Schedule E of Form 1040 or 1040‐SR (unless rental income from your vacation home is tax free).
If you are subject to the passive activity loss limitations, you must complete Form 8582, Passive Activity Loss Limitations, to determine your deduction limit for the year.
If you have income from rental activities and you are not a real estate professional, this income is taken into account in determining the net investment income (NII) tax figured on Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts.
Home Office
The president of the United States works from home, but since he doesn't pay for the costs of the Oval Office, he can't claim any deduction for his home office. But if you work from your home and are self‐employed, you may qualify for write‐offs if certain conditions are met.
Benefit
If you use a part of your home for business, you may qualify to deduct costs related to the home office, including rent (if you lease your residence) or depreciation (if you own your home), maintenance and utilities, and other expenses. In effect, the personal expenses you are already paying become deductible business expenses, so the home office deduction is a write‐off that doesn't require you to pay anything other than what you are already paying. Alternatively, you can opt to use an IRS‐set standard amount for your home office deduction.
Generally, you figure your home office deduction by apportioning expenses to that space. The IRS generally wants you to make the apportionment based on square footage. If you use the IRS‐set simplified method, you can take into account your square footage up to 300 square feet to figure your deduction.
If all your rooms are about the same size, you can opt to make your allocation based on the number of rooms. For example, if you have 8 rooms in your home and one is used for business, then one‐eighth of your home's expenses are part of your home office deduction. If you use the IRS's simplified method, your deduction is $5 per square foot of up to 300 of square feet, for a maximum deduction of $1,500. If you base your deduction on your actual costs, the computation is more complex. There are 2 general categories of deductible expenses—those directly related to the home office and those indirectly related to the home office. The first category includes only costs for the office itself, and these costs are fully deductible; the second category includes costs related to the home in general, and these are deductible to the extent of your allocation.
If you own the home, you can claim depreciation on the portion of the house or other unit (not the land) used as a home office (see later in this chapter under Rentals). Usually, depreciation is figured using a 39‐year recovery period on a straight line basis. However, if the office is within property qualifying as residential rental property (e.g., you use one room in your apartment within an 8‐unit building you own), then depreciation is figured using a 27.5‐year recovery period.
Conditions
To be eligible to treat costs related to a home office as a deductible business expense (regardless of how you figure the deduction), you must first show that the office is one of the following:
- Your principal place of business
- A place to meet or deal with patients, clients, or customers in the normal course of your business
- A separate structure (not attached to your residence) that is used in connection with your business
Then you must show that you use the home office regularly and exclusively for business. Assuming you meet this condition, you must have sufficient income from your home office activity.
PRINCIPAL PLACE OF BUSINESS
The home office must be the prime location for running your business. The business itself need not be your prime activity; you can claim a home office deduction for a sideline or moonlighting business. Usually, prime location means the place where you earn your money. For example, a freelance writer's prime location is his home office.
Your home office is treated as your prime location if it is used for substantial managerial or administrative activities and there is no other fixed location for these activities. For example, an electrician's prime location is the customers' homes where her fees are earned. But if she uses a home office to keep her books, schedule appointments, and order supplies, and she does not have another office, then the home office is treated as her prime location.
PLACE TO MEET OR DEAL WITH CUSTOMERS
You don't have to use your home office as your prime location. You merely have to use it on a regular basis to meet or deal with customers, clients, or patients. For example, an attorney with a downtown office who uses a home office several times each month to meet with clients qualifies as having a deductible home office. Merely using a telephone from a home office to talk with clients or customers is not considered meeting or dealing with them on a regular basis.
SEPARATE STRUCTURE
If you have a freestanding garage, barn, greenhouse, or studio that you use in connection with your business, it qualifies as a deductible home office. It does not have to be used as an office or qualify as a principal place of business or a place to meet or deal with customers. For example, a florist with a store in the city who uses a greenhouse on her property to grow orchids can treat the greenhouse as her home office.
EXCLUSIVE USE TEST
Whether you figure the deduction based on actual expenses or the IRS‐set rate, you must show that you use the home office space regularly and exclusively for business. There is no minimum amount of time that the office must be used to show regular use. Regular use means more than just occasional use.
For purposes of showing exclusive use, you can't, for example, use the family den as an office by day and a family room by night. A piano teacher was able to show that her living room containing her baby grand piano was her home office; her family never used the room for personal reasons. However, incidental use, such as walking through the office to get to personal space because of necessity does not violate the exclusive use test.
You do not have to use an entire room as your office; a portion of a room can qualify. You don't even need to make a physical partition for the space. Just be sure it is used only for business. Furnish it appropriately for your business activity (e.g., a desk, and so on if you run a travel agency business from home).
There is a special rule if you run a day‐care business from home. There is another special rule for storing inventory and samples if you have a retail or wholesale business and no other fixed location for the business. These special rules are explained in IRS Publication 587, Business Use of Your Home.
GROSS INCOME LIMITATION
Your home office deduction cannot be more than your gross income from the home office activity whether you use the actual expense method or the IRS's simplified method. If you use your home office for a profitable business, this limitation should pose no problem. But if your business is merely a sideline generating modest income or a struggling business, you must check whether this limitation applies to you.
Gross income for purposes of the home office deduction means income from the business activity you run from home, reduced by business deductions unrelated to the qualified use of the home.
If you find that gross income is less than your home office deduction, the deduction becomes limited. Under the actual expense method, your deduction for expenses that would otherwise be nondeductible (such as depreciation and utilities) cannot exceed gross income from the home office activity, reduced by the business portion of otherwise deductible expenses. Some expenses (real estate taxes, mortgage interest, and casualty losses) may or may not be subject to the gross income limitation. It's very complicated and depends on whether you claim the standard deduction, or if you itemize whether other limitations apply for personal itemized deduction purposes.
If, after going through the computation, you have an unused home office deduction, you can carry it forward indefinitely. (There is no carryover if you use the IRS's simplified method.) The carryforward can be used in any future year in which there is gross income from the same home office activity to offset it. Using the carryforward is permissible even if you are no longer in the same home office.
Planning Tips
If you were unable to claim the full home office deduction in a prior year due to income limitations, be sure to include any carryover of the home office deduction in your computations for the current year.
If you qualify for a home office, there is an ancillary benefit to consider. Travel to and from your home on business is deductible business travel. In effect, there is no such thing as nondeductible commuting when you have a home office.
Pitfalls
If you are an employee who was forced to work from home due to business closures related to COVID‐19 or remained a remote worker even though safe to return to the company office, you cannot claim a home office deduction. As explained earlier, even though you meet the requirements for the deduction, you're barred from claiming it due to the suspension of miscellaneous itemized deductions (which include unreimbursed employee business expenses) subject to the 2%‐of‐adjusted‐gross‐income floor in 2018 through 2025.
Even if this suspension were not in effect, you cannot claim a home office deduction if you are an employee who leases the space to your corporation. The tax law specifically bars a home office deduction in this case. However, like any homeowner, you can continue to claim your regular deductions, such as mortgage interest, real estate taxes, and casualty and theft losses.
If you use the IRS's optional method and cannot claim a current deduction because of the gross income limitation, you cannot carry over the unused deduction to a future year. And, the year you use the optional method, you cannot claim any carryover of an unused home office deduction from a year in which the actual expense method was used.
When figuring the deduction using actual expenses, all expenses related to your home office are deductible. The cost of landscaping is not part of a home office deduction. Similarly the expenses of a telephone to a home office are not part of your home office deduction. You cannot deduct the basic service charge for the first line to your home. But the cost of a second phone line or even extra charges on the first line are separately deductible as a business expense that is not part of your home office deduction.
Claiming a home office deduction has often been called a red flag, a signal to the IRS to look closely at the deduction. However, if you are entitled to claim the deduction, then by all means do so; just be prepared to back up the position you take on your tax return.
If you own your home, then any depreciation claimed with respect to a home office after May 6, 1997, must be recaptured when your home is sold. Recapture means that this portion of your gain is taxed at a 25% rate (assuming you are in a tax bracket at or above this level). You must report your depreciation even if you qualify to exclude gain on the sale of your home; you cannot use the exclusion to offset depreciation recapture.
Where to Claim the Deduction
As a self‐employed individual, you figure your home office deduction using actual expenses on Form 8829, Expenses for Business Use of Your Home. The deduction using the IRS's simplified method is figured on a worksheet in the instructions to Schedule C.
Timeshares
Owning a timeshare entitles you to use your furnished unit in a resort location for a set period of time each year. In many cases, you can exchange yours for one in another resort or change your fixed time for another. According to the American Resort Development Association, in 2020 approximately 9.9 million households in the U.S. owned one or more timeshares.
Owned for personal use. Timeshares owned for personal reasons are treated in the same way as vacation homes. Thus, the tax breaks available for such ownership include:
- Deducting mortgage interest as long as the debt is secured by the property.
- Deducting real estate taxes. The taxes are deductible whether you are billed directly (as is the case in California) or the tax is separately identified on the timeshare maintenance bills (as is the case in Florida).
As in the case of other realty owned for personal use, you cannot deduct homeowners insurance, maintenance fees, or special assessments. Gain cannot qualify for the home sale exclusion (see Chapter 4) because the timeshare can never be your principal residence. Thus, gain on the sale of your timeshare is taxed as capital gain; any loss is not deductible.
The rules for timeshares owned for investment purposes are explained under the topic of Rentals, which follows.
Rentals
Becoming a landlord by acquiring real estate and renting it out can be a sound financial activity. There is the possibility of making money both from rental income as well as property appreciation upon an eventual sale. The tax law helps to underwrite the cost of being a landlord, allowing for certain tax deductions. But there are limits on and special rules for write‐offs associated with rental properties.
Benefit
If you rent out property, directly to tenants or through an online platform such as airbnb, you can deduct your expenses against the rental income. Net income from rentals may entitle you to claim a qualified business income (QBI) deduction. Any loss resulting from having expenses in excess of rental income can effectively be used to offset your other income, such as salary or dividends.
However, losses from rental activities are subject to the passive loss rules that may restrict your deductions for the current year.
Conditions
If you own realty—a single‐family home, a condo unit, a multifamily home in which you live and rent out a portion, an office building, a strip mall, or any other property—you can deduct expenses related to the property.
EXAMPLES OF DEDUCTIBLE RENTAL EXPENSES
- Advertising to find tenants
- Car expenses to and from the property
- Cleaning and maintenance
- Commissions to real estate brokers when finding tenants
- Depreciation
- Insurance
- Legal and professional fees (but not attorney's fees to buy the property)
- Management fees
- Mortgage interest on rental property
- Repairs
- Security system monitoring fees
- Supplies
- Taxes
- Utilities
PASSIVE LOSS LIMITATIONS
When you rent out property, you usually fall within the passive loss rules (exceptions to these rules are discussed later). Then, generally, your deductions cannot exceed all of your passive activity income from the year (income from this rental activity plus any other passive activities). (The law calls them passive “losses” but really means deductions in excess of rental income.)
Passive activity losses in excess of passive activity income can be carried forward and used in a future year when there is passive activity income to offset them. There is no limit on the carryforward period.
There are 3 key exceptions to the ban on deducting passive losses in excess of passive activity income.
- You can deduct all carryover losses from a passive activity in the year in which you dispose of your interest in the realty in a taxable disposition (e.g., sell your rental property).
- You can deduct up to $25,000 of passive activity losses in excess of passive activity income from a rental activity in which you actively participate (e.g., approve new tenants, decide on rental terms, and authorize capital expenditures and repairs). The $25,000 limit begins to phase out when your modified adjusted gross income exceeds $100,000 and is completely phased out when MAGI reaches $150,000. MAGI for this purpose means AGI without taxable Social Security benefits, the exclusion for interest from U.S. savings bonds used for higher education, the exclusion for employer‐paid adoption expenses, deductions for IRA contributions, the deduction for contributions to Archer medical savings accounts, and student loan interest. If you are married filing separately, see the limitation discussed earlier in this chapter.
- You are a real estate professional exempt from the passive loss rules. If you are in the real estate business and want to check whether you are treated as a real estate professional exempt from the passive loss rules, see the instructions to IRS Form 8582. Just know that if you have a full‐time job in addition to your real estate activities, it's highly unlikely that you'll qualify as a real estate professional.
QUALIFIED BUSINESS INCOME DEDUCTION
Regardless of whether you are actively or passively involved with your real estate rentals, if you show a profit you may be eligible for a deduction of up to 20% of your qualified business income (QBI). The QBI deduction, which is a personal deduction based on your rental income and can be taken whether you itemize or claim the standard deduction, is discussed in more detail in Chapter 14.
The IRS has provided a safe harbor under which a rental real estate enterprise is treated as a trade or business for purposes of the QBI deduction. All of the following conditions must be met:
- You must keep separate books and records to reflect income and expenses for each rental real estate enterprise.
- For rental real estate enterprises that have been in existence less than 4 years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least 4 years, in any 3 of the 5 consecutive taxable years that end with the taxable year, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise.
- You must maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, you can provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. These records are to be made available for inspection at the request of the IRS.
- You or the relevant pass‐through entity (RPE), such as a limited liability company in which you have an interest, attaches a statement to a timely filed original return for each taxable year in which you or RPE relies on the safe harbor. An individual or RPE with more than one rental real estate enterprise relying on this safe harbor may submit a single statement but the statement must list the required information separately for each rental real estate enterprise.
Planning Tips
Depreciation is a no‐cost deduction (you don't spend any dollars to claim the write‐off, other than buying the property). How do you figure this valuable write‐off called depreciation? It is a deduction only for the building (you can't depreciate land), so you must allocate the cost of the property between the building and the land.
If you convert personal property to rental property (for example, you move from your home and rent it out), your basis for depreciation purposes is your basis (as figured earlier) or the fair market value of the home at the time of conversion, whichever is less (exclusive of the land).
The amount you claim for depreciation is based on the month in which you place the property into service as a rental and the type of realty involved:
- Residential rental property is depreciated over a period of 27.5 years using the straight‐line method and a midmonth depreciation convention. Residential rental property is a building for which 80% or more of the gross rental income for the year is rental income from dwelling units. So, if you own an apartment building with stores at street level, you must see whether the property meets the 80% test.
- Nonresidential property is depreciated over a period of 39 years.
Depreciation is simply your basis in the home or building (but not the land) multiplied by the depreciation rate from the IRS table. Table 10.1 shows depreciation rates for residential property. Table 10.2 shows depreciation rates for nonresidential property.
TABLE 10.1 Depreciation Rates for Residential Rental Property
| Month | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 |
| 1 | 3.485% | 3.182% | 2.879% | 2.576% | 2.273% | 1.970% | 1.667% | 1.364% | 1.061% | 0.758% | 0.455% | 0.152% |
| 2–9 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 |
| 10 | 3.637 | 3.637 | 3.637 | 3.637 | 3.637 | 3.637 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 | 3.636 |
For years 11–28, see IRS Publication 946, How to Depreciate Property.
TABLE 10.2 Depreciation Rates for Nonresidential Rental Property (Placed in Service after May 13, 1993)
| Month | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 |
| 1 | 2.461% | 2.247% | 2.033% | 1.819% | 1.605% | 1.391% | 1.177% | 0.963% | 0.749% | 0.535% | 0.321% | 0.107% |
| 2–39 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 | 2.564 |
If you sublease property—you are a tenant who leases the property to someone else—you cannot claim a depreciation deduction. Depreciation for the cost of the building can only be claimed by the owner of the property.
Leasehold improvements that you make can be deducted separately from depreciation on the building. Write‐offs for leasehold improvements are explained later in this chapter.
If your landlord activities rise to the level of being a business, you may be eligible for the qualified business income deduction (see Chapter 14).
Pitfall
Depreciation claimed on your rental realty is subject to a special capital gain rate for recaptured depreciation. This means that the gain you realize on the sale is taxed at 25% to the extent of depreciation deductions you have claimed. Gain in excess of this amount is taxed at no more than 20%, or 15% for most taxpayers (assuming you owned the property for more than one year).
Where to Claim the Deduction
You report your rents and expenses in Part I of Schedule E of Form 1040 or 1040‐SR. If you own a multifamily home in which you live, the portion of mortgage interest and real estate taxes is allocated between Schedule E (for the rental portion) and Schedule A of Form 1040 or 1040‐SR (for the personal portion of the home, assuming you itemize deductions).
If you own an interest in rental realty through a partnership or limited liability company that files a partnership return, you report your share of rental income or losses on Schedule E (you obtain the amount you must report from a Schedule K‐1 that is given to you by the entity).
You must also complete Form 8582, Passive Activity Loss Limitations, to determine your deduction limit for the year under the passive activity rules.
Low‐Income Housing Credit
The federal government wants to encourage investments in housing to accommodate low‐income individuals. To make such investments attractive to investors, special tax credits have been made available. These credits effectively operate to replace the rental income investors do not receive because of the rent reductions or breaks provided to certain renters because of their income levels.
Benefit 
If you invest in low‐income housing—to build it or substantially renovate existing structures—you may be eligible for a tax credit each year for a period of 10 years, generally starting with the year the building is placed in service. The amount of the credit depends on whether the building is new and whether any federal subsidies were used for construction or rehabilitation purposes.
The credit is based on 70% of the qualified basis of each new low‐income housing building placed in service after 1986 or 30% of the qualified basis in the case of federally subsidized new or existing buildings. The credit itself is the present value of the 10 annual credit amounts determined as of the last day of the first year of the credit period. However, there is a minimum 9% for newly constructed nonfederally subsidized buildings.
Conditions
You can invest in low‐income housing directly, by building the units or rehabilitating existing ones, or by putting money into a limited partnership that does the building or rehabilitating for you. Either way, to qualify for a credit, the building must be considered a low‐income housing building.
LOW‐INCOME HOUSING BUILDING
Low‐income housing does not mean the property must be located in the slums or that the building itself is a tenement. Rather, the tax law requires only that the building offer a certain percentage of the rental units to tenants with income below fixed levels. For example, in the case of housing in suburban areas and smaller towns, the building is considered to be low‐income housing if the tenants earn no more than 60% of the local median income. How do you know if your building qualifies? You must receive certification from an authorized housing credit agency. The agency allocates the credit to you on Form 8609, Low‐Income Housing Credit Allocation Certificate.
The building must have been constructed after 1986; older buildings don't qualify.
Planning Tip
Generally, the first year of the credit is the year in which the building is placed in service for low‐income housing. However, you can elect to start claiming the credit in the following year just by indicating your election on Form 8609. You may wish to do so if you cannot fully benefit from the credit in the year the building is placed in service (see “Pitfalls” that follow) or if you will have more income to offset in the following year.
Pitfall
If you dispose of your interest before the end of a set period, you are subject to recapture. This means that part of the benefit you received from claiming the credit is reported as an additional tax you owe in the year of recapture. The building must continue to meet certain requirements for a 15‐year period. If not, then your recapture is figured on Form 8611, Recapture of the Low‐Income Housing Credit.
Where to Claim the Credit
You figure your credit on Form 8586, Low‐Income Housing Credit. The credit is part of the general business credit, which is figured on Form 3800, General Business Credit.
You may also need to figure whether the passive activity restrictions apply to your claiming the credit in the current year. You do this by completing Form 8582‐CR, Passive Activity Credit Limitations.
The amount of the credit that can be claimed this year is then entered on Schedule 3 of Form 1040 or 1040‐SR.
Rehabilitation Credit
Fix it up or tear it down? The tax law provides a key incentive for restoring certain older properties. The incentive is a tax credit that may be claimed if certain conditions are met.
Benefit
If you spend money fixing up an old building, you may be eligible to claim a tax credit. The credit is 20% for qualified rehabilitation expenditures for a certified historic structure. The credit is taken ratably over 5 years.
There is no overall dollar limit on the credit. However, there are certain limitations that may restrict the amount you can claim in the current year.
Conditions
There are 2 conditions:
- The building must be a historic structure
- The costs must be qualified rehabilitation expenditures that exceed a certain amount
HISTORIC STRUCTURES
The credit applies to both residential and nonresidential buildings (such as industrial and commercial buildings). The only criterion is that the building is a historic structure that has been recognized by a national or state registry (placed on the National Register of Historic Places or located in a registered historic district and certified by the Secretary of the Interior as being of historic significance to the district).
The National Park Service must certify that your planned rehabilitation of the building is in keeping with its historic status designation.
MINIMUM REHABILITATION
You can't claim the credit simply for adding a doorbell or making other minor renovations. The credit is limited to expenses of at least a certain amount: $5,000 or your adjusted basis in the building, whichever is greater.
The expenditures must be made within a 24‐month period. This period is extended to 60 months if the rehabilitation is undertaken pursuant to a written architectural plan and specifications are completed before the rehabilitation begins.
Planning Tips
When shopping for real estate to purchase for investment or business, consider the impact that claiming the credit may have on your fix‐up costs. Also explore any federal or state grants that may be available for restoring historic structures.
Check to see if there are state income tax credits or other incentives (such as property tax abatements) for rehabilitating certified historic structures. The rehabilitation credit can offset both regular tax and the alternative minimum tax.
Pitfalls
The tax credit for rehabilitating an old building falls under the passive loss rules. This means that the credit you are otherwise entitled to claim may be limited by passive activity restrictions. For more details, see the instructions to Form 8582‐CR, Passive Activity Credit Limitations.
If you want to make a donation of a conservation easement, such as a façade easement (see Chapter 6), the amount of the contribution must be reduced by any rehabilitation credit claimed in the prior 5 years.
Where to Claim the Credit
You figure your credit on Form 3468, Investment Credit. The credit is part of the general business credit, which is figured on Form 3800, General Business Credit.
You may also need to figure whether the passive activity restrictions apply to your claiming the credit in the current year. You do this by completing Form 8582‐CR, Passive Activity Credit Limitations.
The amount of the credit that can be claimed this year is then entered on Schedule 3 of Form 1040 or 1040‐SR.
Like‐Kind Exchanges
If you swap real property held in business or for investment purposes and meet certain requirements, gain on the exchange can be deferred. You may see like‐kind exchanges being referred to as “tax free,” but this is a misnomer; you're merely postponing having to pay tax on your gain.
Benefit 
When you trade realty for other realty that is “like kind,” gain or loss on the trade is deferred. So if you have a gain, you don't pay tax on it now; you pay tax on it when you dispose of the property you got in the exchange, assuming that disposition is a taxable transaction and not another like‐kind exchange. This is accomplished by reducing your basis in the property acquired by the amount of gain not recognized on the trade. However, if you also receive cash or other non‐like‐kind property on the trade, you must report your gain to the extent of this other property (called “boot”), which is explained later.
Conditions
The main condition for deferring gain on a trade of realty is that the property given up and the one acquired in the trade are like kind. If the trade is not simultaneous, you must meet certain time limits.
LIKE‐KIND PROPERTY
Most realty held for business or investment purposes is like kind even though one property may be very dissimilar to another. Examples of like‐kind realty swaps:
- Commercial property for residential rental property
- A lease that still has at least 30 years to run for an ownership interest in realty
- Improved property for unimproved property
- Lots in urban areas for lots in rural areas
Not all real property can be exchanged to produce tax deferral. Nonqualifying real property includes:
- Main home
- Real property located outside the United States cannot be part of a like‐kind exchange. You can't swap a building in Canada for one in the U.S. and defer your gain.
- Vacation homes and second homes unless an IRS‐set safe harbor is met (see Rev. Proc. 2008‐16).
- Fixer uppers and newly built homes (these are considered “stock in trade” that cannot be exchanged for tax deferral).
You can trade multiple properties, as long as they are all like kind.
NON‐SIMULTANEOUS EXCHANGES
You don't have to trade properties simultaneously. But if you give up property (the “relinquished property”) and receive the replacement later on (a “deferred exchange”), or receive a replacement but don't give up property for a while (a “reverse exchange”), you must watch for certain time limits in order for the trade to enjoy like‐kind exchange treatment. And you may use a qualified intermediary, such as an escrow company, to facilitate the trade without you collecting sales proceeds, which is an action that kills like‐kind exchange treatment.
There are 2 key time limits:
- You have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be a legal description (e.g., street address or distinguishable name) in writing, signed by you and delivered to a person involved in the exchange, such as the seller of the replacement property or the qualified intermediary. Notice to your attorney, real estate agent, accountant, or similar persons acting as your agent is not sufficient. You can identify up to 3 potential properties of any value or more than 3, but there are value limits on the identified properties.
- The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45‐day limit.
For reverse exchanges, the IRS has created a safe harbor that essentially uses the same time limits. For more information, see Rev. Proc. 2000‐37.
RECEIVING BOOT
If you receive anything over and above the property, such as cash or the payment for you of certain closing costs, the additional property is called “boot.” You must report taxable gain to the extent of boot received.
If you pay additional cash on the exchange, it becomes part of your tax basis for the acquired property.
Planning Tip
Watch out for tax scams that pitch the use of “tax‐free exchanges” for vacation homes or second homes used solely for personal purposes. These do not qualify for tax deferral of gain on the trade.
Pitfalls
If you have a loss, it is advisable to sell the property so you can take the loss for tax purposes. If you exchange the property, you cannot take the loss now; the same deferral rule for gains applies to losses.
Monitor the time limits for non‐simultaneous exchanges carefully. You cannot get an extension of time other than if you're delayed by a federally‐declared disaster.
Where to Report the Like‐Kind Exchange
You report the like‐kind exchange on Form 8824, Like‐Kind Exchanges, and file it with Form 1040 or 1040‐SR. If you have to report gain on the exchange (e.g., you receive boot), it is reported on Form 4797, Sales of Business Property.
Deduction for Energy‐Efficient Commercial Buildings
It has been estimated that commercial buildings use one‐quarter of all domestic energy consumption. To encourage owners and lessees of commercial property to make certain energy improvements, there is a special deduction.
Benefit
The cost of energy‐efficient property can be deducted up to $1.88 per square foot. A reduced deduction of 63¢ per square foot can be claimed for a building that achieves only partial energy savings.
Conditions
To qualify for the full deduction in 2022, the addition of energy‐efficient property must help a commercial building achieve a 50% energy savings as compared with similar property that meets benchmarks set by the Reserve Standard 90.1 of the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America published 2 years prior to the start of construction. The savings is measured by the reduction in cost (not in the actual units consumed). Cost is determined on a fuel‐neutral basis (e.g., without regard to whether the building is heated by gas, oil, or electricity) by reference to the Standard and not on the basis of the owner's actual costs.
The partial deduction (63¢ per square foot in 2022) is allowed for a building that fails the 50% energy‐savings requirement but meets a lesser standard.
The deduction applies to improvements made to:
- The interior lighting system
- The heating, cooling, ventilation, and hot water systems
- The building envelop (exterior)
The building owner must obtain certification of a plan to reduce overall energy costs before installing the property. There are various ways to satisfy the certification requirement, including use of approved software to calculate energy consumption.
Planning Tip
Check for state tax incentives for making energy improvements. Many states provide deductions and/or tax credits for these improvements.
Pitfall
The basis of the property must be reduced by the amount of any deduction claimed. This will have the effect of reducing allowable depreciation for the property.
Where to Claim the Deduction
The deduction is a business expense reported by the building's owner or lessee on the proper tax return.
Qualified Improvement Property
If you make capital improvements to the interior of these commercial facilities, a deduction for your outlays is not tied to depreciation over 39 years for the cost of the building. Instead, you may be able to take significant write‐offs in the year you make the expenditures and put the property into service.
Benefits
Capital improvements (not repairs) made to qualified improvement property can be written off using:
- Section 179 deduction (first‐year expensing), up to $1,080,000 in 2022.
- Bonus depreciation (another first‐year depreciation allowance) of 100% of expenditures.
- Regular depreciation. Qualified improvement property has a 15‐year recovery period. This comes into play, however, only if costs are not fully written off using first‐year expensing and/or bonus depreciation.
Conditions
The deductions apply only to qualified improvement property. Qualified improvement property is an improvement to the interior of a commercial building that has already been placed in service (i.e., not new construction). However, certain improvements are specifically excluded from this definition:
- Improvements that enlarge the building
- Improvements that change the internal structural framework of the building
- An elevator or escalator
The rules for first‐year expensing, bonus depreciation, and regular depreciation are covered in Chapter 14 under “Equipment Purchases.”
Planning Tips
Capital improvements that cannot be treated as qualified improvement property are nonetheless deductible. The cost may have to be recovered through depreciation or may qualify for more immediate write‐offs. It's advisable to conduct a cost segregation study to analyze improvements to a building structure and each key building system to determine maximize write‐offs. The IRS has a Cost Segregation Audit Technique Guide, which was updated in 2022, at https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents, which details how such an analysis works. The key building systems are the plumbing system, electrical system, HVAC system, elevator system, escalator system, fire protection and alarm system, gas distribution system, and the security system.
There is a special safe harbor election for small taxpayers that allows improvements to be treated as ordinary repairs, which are currently deductible (i.e., not capitalized and deducted using expensing, bonus depreciation, and regular depreciation). This safe harbor applies if you are in business with average annual gross receipts less than $10 million and you own or lease property with an adjusted basis of $1 million or less. The safe harbor deduction can be claimed if the total amount paid for improvements does not exceed the lesser of 2% of the building's basis or $10,000.
Pitfall
Deductions related to qualified improvement property are limited to those “made by the taxpayer.” If the landlord gives the tenant an allowance for improvements, the tenant claims the deduction (various conditions apply).
Where to Claim the Deduction
Deductions for first‐year expensing, bonus depreciation, and regular depreciation are reported on Form 4562, Depreciation and Amortization. Total deductions from this form are then reported on the applicable business form (e.g., Schedule C for self‐employed individuals, Schedule E for landlords).
Conservation Easements
You can benefit from your realty without disposing of it if you're willing to share. You can enjoy a current tax deduction if you donate a conservation easement to a charity, such as a local land trust. Find details in Chapter 6.