10 Costly Tax Mistakes Real Estate Investors Make (And the IRS Penalties You'll Pay)

Every real estate investor thinks they're saving money at tax time. Many are actually costing themselves thousands — through missed deductions, incorrect classifications, sloppy record-keeping, or outright errors that trigger audits.

The IRS collected $4.7 billion in civil penalties from individual taxpayers in a recent fiscal year. A disproportionate share comes from real estate investors, whose returns are more complex than average and whose deductions draw more scrutiny.

Here are the 10 most costly mistakes, what they cost you, and exactly how to fix them.

Mistake 1: Not Claiming Depreciation

Cost: $5,000-$15,000+ per property over your holding period

This is the single most expensive mistake a rental property owner can make — and it's shockingly common among self-filers and investors using generalist CPAs.

Why It Happens

Investors think depreciation is optional: "I'll skip it now and claim it later" or "My property is appreciating, so depreciation doesn't make sense."

Why It's Devastating

Under IRC §1250(b)(3), when you sell the property, the IRS recaptures depreciation based on the amount allowable — not the amount you actually claimed. This means:

• If you claim depreciation: you get the annual tax deduction AND pay 25% recapture at sale
• If you DON'T claim depreciation: you get NO annual deduction but STILL pay 25% recapture at sale

You pay the recapture tax either way. Not claiming depreciation is literally throwing money away.

Example: Property with $256,000 depreciable basis, held 10 years.

• Depreciation you should have claimed: $93,090
• Annual tax savings at 22%: $2,048/year × 10 years = $20,480 lost
• Recapture at sale (either way): $93,090 × 25% = $23,273

You pay the $23,273 recapture whether you claimed the deductions or not. Missing them costs you $20,480 in cash.

The Fix

File Form 3115 (Application for Change in Accounting Method) with your next tax return. Use the automatic consent procedures under Revenue Procedure 2015-13. This allows a §481(a) adjustment — a one-time catch-up of all missed depreciation, taken entirely in the year of change.

No amended returns. No IRS approval needed. Just file the form and claim everything you missed in one year.

Mistake 2: Classifying Improvements as Repairs

Cost: 20% accuracy-related penalty + interest + lost depreciation benefits

The repair vs. improvement distinction is the most litigated issue in rental property taxation. Get it wrong, and you're either:

• Overstating deductions (deducting an improvement as a current-year repair) → IRS disallows and penalizes
• Understating deductions (capitalizing a repair as an improvement) → You defer deductions you could take now

The IRS Framework: The BRA Test

Under the tangible property regulations (Reg. §1.263(a)-3), an expenditure must be capitalized if it results in a:

• Betterment: Fixes a pre-existing defect, enlarges the property, or increases capacity
• Restoration: Returns the property to like-new condition or replaces a major component
• Adaptation: Changes the property's use

Each test is applied to the unit of property — for buildings, each major system (HVAC, plumbing, electrical, roof, etc.) is a separate unit.

Example that trips people up: Replacing 60% of a roof. Is it a repair or improvement?

• Patching a leak: Repair (maintaining current condition)
• Replacing the entire roof: Improvement (restoration of a major component)
• Replacing 60% of the roof: Likely improvement (restoration — replacing a major portion of the roof system)

IRS Penalties for Getting It Wrong

• Accuracy-related penalty (IRC §6662): 20% of the tax underpayment
• Interest: Federal short-term rate + 3% (currently ~8%), compounding daily from the due date

Example: You deducted a $15,000 bathroom [renovation](/blog/bathroom-renovation-cost-guide) as "repairs." The IRS reclassifies it as an improvement. You should have depreciated it over 27.5 years ($545/year) instead of deducting $15,000 in one year.

• Overstated deduction: $15,000 - $545 = $14,455
• Tax underpayment: $14,455 × 24% = $3,469
• Accuracy-related penalty: $3,469 × 20% = $694
• Interest (2 years at 8%): ~$555
• Total cost: $4,718 on a single misclassified expense

The Fix

• Apply the BRA test to every expenditure over $2,500
• Use the de minimis safe harbor for items $2,500 or less (annually elected)
• Use the routine maintenance safe harbor for recurring activities
• When in doubt, capitalize it — you can always do a cost segregation study later to accelerate depreciation

Mistake 3: Missing the De Minimis Safe Harbor Election

Cost: $500-$2,000/year in deferred deductions

The de minimis safe harbor (Reg. §1.263(a)-1(f)) allows you to immediately expense items costing $2,500 or less per invoice/item instead of capitalizing and depreciating them.

Why People Miss It

It requires an annual election — a statement attached to your tax return. No statement = no safe harbor. Tax software sometimes doesn't prompt for it.

Example items you're missing:

• Garbage disposal: $400
• Ceiling fan: $200
• Light fixtures: $350
• Smart thermostat: $250
• Smoke detectors: $150
• Bathroom vanity: $800
• Water heater (some models): $1,800

Without the election, each of these items technically should be capitalized and depreciated over 27.5 years. A $1,800 water heater yields only $65/year in depreciation versus an immediate $1,800 deduction.

The Fix

Attach this statement to your tax return annually:

"Under Reg. §1.263(a)-1(f)(ii), [your name/entity] elects to apply the de minimis safe harbor election for the taxable year ended December 31, 2026. The taxpayer agrees to apply this safe harbor to all qualifying amounts paid during the tax year for tangible property that does not exceed $2,500 per invoice or per item."

Mistake 4: Wrong Land-to-Building Ratio

Cost: $2,000-$10,000+ in incorrect depreciation over the holding period

Land is not depreciable. Only the building (and improvements) generate depreciation deductions. Allocating too much to land means less depreciation; too little triggers audit risk.

Common Errors

• Using the purchase contract split: Rarely reflects actual values
• Arbitrary allocation (e.g., 10% land in a high-value urban area): The IRS will challenge this
• Using assessed value without verification: County assessments can be outdated

IRS Scrutiny

The IRS examines land allocations during audits, especially when:

• Land percentage is below 15% in urban/suburban areas
• The allocation doesn't match the county assessor's ratio
• The allocation changed between properties without explanation

Example: You buy a condo in San Francisco for $800,000 and allocate $80,000 (10%) to land. The county assessor allocates 40% to land. The IRS adjusts your allocation:

• Your depreciation: $720,000 ÷ 27.5 = $26,182/year
• IRS-adjusted depreciation: $480,000 ÷ 27.5 = $17,455/year
• Overstatement: $8,727/year × 24% = $2,095/year in overstated deductions
• Over 5 years: $10,473 + penalties + interest

The Fix

Use one of these defensible methods:

1. County tax assessor allocation (most commonly accepted)
2. Qualified appraisal (strongest defense but costs $300-$500)
3. Comparable sales analysis (land-only sales in the area)

Document your method. Consistency across properties strengthens your position.

Mistake 5: Ignoring Passive Activity Rules

Cost: 20% penalty + full payback of improperly deducted losses

If your Modified Adjusted Gross Income exceeds $150,000 and you're not a Real Estate Professional, your rental losses are fully suspended under IRC §469. They cannot offset W-2 income, business income, or investment income.

The Expensive Error

Taking rental losses against W-2 income when MAGI is above the phase-out threshold. This is one of the most common audit triggers for real estate investors.

Example: MAGI of $200,000. Rental loss of $20,000 deducted against W-2 income.

• Disallowed deduction: $20,000
• Tax underpayment: $20,000 × 24% = $4,800
• Accuracy-related penalty: $4,800 × 20% = $960
• Interest (if caught 3 years later at 8%): ~$1,152
• Total cost: $6,912

What About the $25,000 Allowance?

The allowance phases out completely at $150,000 MAGI. Between $100,000 and $150,000, it reduces by $1 for every $2 of MAGI above $100,000.

At $150,000+ MAGI: Allowance = $0. Period.

The Fix

• Track MAGI carefully each year
• File Form 8582 with every return that includes rental losses
• Suspended losses aren't wasted — they accumulate and are fully deductible when you sell the property (IRC §469(g))
• Consider qualifying for [Real Estate Professional Status](/blog/real-estate-professional-status) if you have significant rental losses

Mistake 6: Failing to Qualify for (or Document) Real Estate Professional Status

Cost: $10,000-$100,000+/year in lost deductions for high-income investors

REPS is the most powerful tax status available to rental investors. It removes the passive activity limitations entirely. But the IRS challenges REPS claims aggressively — and wins most cases where documentation is weak.

Requirements (IRC §469(c)(7))

Both must be met:

1. 750+ hours in real property trades or businesses
2. More than 50% of total working hours in real property trades

How the IRS Wins REPS Cases

The Tax Court has denied REPS claims in numerous cases due to:

• No contemporaneous time log: Reconstructed logs created during audit prep are given little weight (Moss v. Commissioner, T.C. Memo 2017-61)
• Hours don't add up: 750 hours = 14.4 hours/week, every week. If you have a full-time W-2 job, meeting the 50% test is nearly impossible
• Vague activity descriptions: "[Property management](/blog/property-management-complete-guide)" isn't enough. Log specific activities: "Reviewed tenant application for 742 Elm Street — 45 minutes"
• No grouping election filed: Each property is treated as a separate activity unless you file a grouping election (IRC §469(c)(7)(A)). Material participation must be met for each property individually without the election

Penalties for Invalid REPS Claims

• All rental losses reclassified as [suspended passive losses](/blog/tax-loss-harvesting-real-estate)
• Tax underpayment on disallowed losses + 20% accuracy penalty + interest
• On a $60,000 loss at 32%: underpayment of $19,200 + penalty of $3,840 = $23,040+

The Fix

• Maintain a daily time log — date, activity, property, hours
• Use apps like Toggl or a spreadsheet updated weekly (not annually)
• File the grouping election in the first year you claim REPS
• Keep the election statement with your records permanently (it's irrevocable)

Mistake 7: Not Issuing 1099s to Contractors

Cost: $280-$630 per missing form + potential loss of the deduction

If you pay any individual or unincorporated entity $600 or more during the tax year for services, you must issue Form 1099-NEC by January 31.

Who Needs a 1099

• Plumbers, electricians, handymen (sole proprietors or LLCs)
• Property managers (if not a corporation)
• Attorneys (always, even if incorporated)
• Cleaning services
• Landscapers

Who Doesn't

• Corporations (C-corps and S-corps, except attorneys)
• Employees (they get W-2s)
• Payments made via credit card or PayPal (the payment processor issues 1099-K)

IRS Penalties (IRC §6721/6722)

Maximum annual penalties for small businesses (gross receipts ≤ $5M):

• $220,500 for late filing
• $660,500 for intentional disregard (no cap)

The Deduction Risk

Some CPAs argue that failure to issue a required 1099 can result in disallowance of the associated deduction. While the IRS doesn't explicitly state this, it creates an unfavorable audit posture.

The Fix

• Get Form W-9 from every [contractor](/blog/diy-vs-contractor) before you make the first payment
• Use accounting software that tracks 1099-eligible payments
• File electronically through IRS FIRE system or services like Tax1099.com
• Deadline: January 31 to the recipient; January 31 to the IRS (electronic filing)

Mistake 8: Commingling Personal and Rental Finances

Cost: Disallowed deductions + audit complexity + potential entity veil-piercing

Using your personal bank account for rental income and expenses makes it nearly impossible to accurately track deductions — and gives the IRS auditor a reason to dig deeper.

The Audit Problem

When rental and personal transactions are mixed in one account, the auditor must review every transaction to separate business from personal. This:

• Extends audit duration significantly
• Increases the likelihood of errors (in the IRS's favor)
• Creates an inference that you're not treating the activity as a business
• If you hold property in an LLC, commingling can pierce the corporate veil, eliminating your liability protection

The Fix

• Open a dedicated bank account for each rental property (or one account for all rentals, minimum)
• Get a dedicated credit card for rental expenses
• Never deposit personal funds or pay personal expenses from rental accounts
• Reconcile monthly — 15 minutes that could save thousands in an audit

Mistake 9: Forgetting to Report Security Deposit Income

Cost: Underreported income + accuracy penalty

Security deposits have specific tax rules that most investors get wrong:

When Security Deposits ARE Taxable

• You apply the deposit to unpaid rent → income in the year applied
• You keep the deposit for damages → income in the year you determine it won't be returned
• The lease designates the deposit as final month's rent → income when received

When Security Deposits Are NOT Taxable

• You receive it with the intention and obligation to return it → not income
• It sits in your escrow account untouched → not income (but interest earned on it IS)

Example: Tenant moves out on October 15. You withhold $800 for damages and return $700. The $800 is income in October's tax year — reported on Schedule E, Line 3.

Common Error

Not reporting the $800 because "it was just a deposit." The IRS considers this rental income once you determine it won't be returned.

Penalty: If the unreported amount causes an understatement exceeding $5,000 or 10% of the correct tax (whichever is greater), the 20% accuracy-related penalty applies.

Mistake 10: Not Planning for [Depreciation Recapture](/blog/depreciation-real-estate-guide) at Sale

Cost: Unexpected 25% tax bill that derails your exit strategy

Many investors buy and hold for years, enjoying depreciation deductions, without planning for the recapture tax when they eventually sell.

How Recapture Works (IRC §1250)

When you sell a rental property, all depreciation claimed (or allowable — see Mistake 1) is "recaptured" and taxed at a maximum rate of 25%. This is in addition to the 15% or 20% capital gains rate on the remaining gain.

Example: Bought for $300,000, held 15 years, selling for $500,000.

• Depreciation claimed: $145,455 ($256,000 basis ÷ 27.5 × 15 years, prorated)
• Adjusted basis: $300,000 - $145,455 = $154,545
• Total gain: $500,000 - $30,000 selling costs - $154,545 = $315,455
• Depreciation recapture: $145,455 × 25% = $36,364
• Remaining capital gain: $170,000 × 15% = $25,500
• NIIT (if applicable): $315,455 × 3.8% = $11,987
• Total federal tax: $73,851

If you didn't plan for this, you're writing a check for almost $74,000 at closing.

Why Investors Get Blindsided

• They focused on cash flow and appreciation without modeling the exit
• They assumed a [1031 exchange](/blog/1031-exchange-guide) would be easy (they can be complicated and time-sensitive)
• They didn't account for the NIIT on top of everything else

The Fix

• Model your exit tax before you sell — not during escrow
• Line up a 1031 exchange before listing the property (identify your QI and target properties)
• Consider installment sales to spread the gain across tax years
• If MAGI is below $96,700 (MFJ), the 0% capital gains rate might apply to some of the gain — time your sale for a low-income year (retirement, sabbatical)
• Build a tax reserve: Set aside 20-30% of expected gain for taxes if you're not doing a 1031

The Penalty Reference Table

The Prevention Framework

1. Organize from Day 1: Separate bank accounts, receipt tracking, mileage logs
2. Understand the rules before filing: This article covers the big ones — bookmark it
3. Elect safe harbors annually: De minimis, routine maintenance, small taxpayer
4. Document everything: Hours for REPS/QBI, expense purposes, contractor W-9s
5. Work with a [real estate CPA](/blog/how-to-build-real-estate-team): A generalist might file correctly but will miss optimization opportunities worth far more than the fee difference
6. Review before you sign: Even if a CPA prepares your return, you are responsible for its accuracy
7. Model your exit strategy: Know the tax consequences of selling before you list
8. File on time: Even if you can't pay, file the return to avoid the 5%/month failure-to-file penalty (which is 10x the failure-to-pay penalty)
9. Keep records for 7 years: The standard is 3 years, but 6 years if you underreport by 25%+, and indefinitely for fraud or failure to file. Seven years covers almost every scenario.
10. Treat your rental as a business: Because the IRS does.

What to Do If You've Made These Mistakes

For Missed Depreciation (Mistake 1)

File Form 3115 with your next return. Automatic consent. One-time catch-up.

For Prior-Year Errors (Mistakes 2-9)

File Form 1040-X (Amended Return) within 3 years of the original filing date. If the error resulted in overpayment, you'll get a refund. If it resulted in underpayment, you'll owe tax plus interest — but voluntary correction typically avoids the 20% penalty.

For Ongoing Issues

Engage a CPA who specializes in real estate. The fee ($500-$2,000 for a rental portfolio) is a fraction of the penalties and missed deductions you're likely experiencing.

The tax code rewards real estate investors who play by the rules — and punishes those who don't understand them. These 10 mistakes are entirely avoidable. Fix them now, and your future self will thank you.

This article is for informational purposes only and does not constitute tax advice. Consult a qualified tax professional for guidance specific to your situation.

Related Articles

• 1031 Exchange for Beginners: Complete Guide to Deferring Capital Gains Taxes
• 1031 Exchange: Defer Taxes, Build Wealth Faster
• Cost Segregation Study Guide: How Real Estate Investors Accelerate Depreciation to Save Thousands