Rental real estate can generate significant depreciation deductions, especially when paired with a cost segregation study. But many investors in McAllen and across Texas discover that those losses are “suspended” and cannot offset their other income. The reason is the passive activity loss rules, and the exception that matters most is real estate professional status (REPS).
How passive loss rules limit rental losses
Under Internal Revenue Code §469, rental activities are generally treated as passive. Passive losses can usually offset only passive income; unused losses carry forward until you have passive income or sell the property. A limited $25,000 allowance exists for active participants, but it phases out at higher incomes, which is why it rarely helps high earners.
What real estate professional status changes
If you qualify as a real estate professional and materially participate in your rental activities, those rentals are not automatically passive. Losses, including accelerated depreciation, may then offset non-passive income such as business profits or wages.
To qualify for a given year, generally:
- More than half of the personal services you perform in all trades or businesses must be in real property trades or businesses in which you materially participate; and
- You must perform more than 750 hours of services during the year in those real property trades or businesses.
For married couples filing jointly, one spouse must meet both tests on their own. Material participation in the rentals is a separate requirement, and many investors make an election to treat all rental interests as a single activity.
Where cost segregation fits
A cost segregation study identifies parts of a building that can be depreciated over 5, 7 or 15 years instead of 27.5 (residential) or 39 (commercial) years. Combined with bonus depreciation, it can move a large share of a property’s cost into the first year. Recent federal legislation restored 100% bonus depreciation for qualifying property acquired after January 19, 2025. Confirm current rules for your acquisition date before relying on it.
Without REPS (or another path to non-passive treatment), those front-loaded deductions may simply be suspended. With REPS, they may reduce tax on other income now.
Document everything
REPS is one of the most frequently examined positions on individual returns. Keep contemporaneous time logs showing dates, hours and activities, and keep records of your other work hours too. Reconstructing logs after an audit begins is far weaker evidence.
Plan before you buy
- Model whether a cost segregation study pays for itself on the specific property.
- Consider depreciation recapture when you eventually sell, and whether a 1031 exchange fits your plan.
- Decide whether your hours, or a spouse’s, can realistically meet the tests.
If you are acquiring or holding property in the Rio Grande Valley or elsewhere in Texas, our real estate tax planning team can help you evaluate these strategies before the year closes.
Circular 230 notice: This article is general educational information, not a formal tax opinion or advice for your specific situation. Tax outcomes depend on your individual facts. Formal advice is provided only under a signed engagement agreement.