Tax-Loss Harvesting in Real Estate: How to Use Paper Losses to Cut Your Tax Bill

Tax-loss harvesting is a well-known strategy in the stock market: sell losing investments to offset gains elsewhere. But in real estate, the concept goes much deeper — and the potential tax savings are significantly larger.

Real estate offers something stocks don't: manufactured losses. Through depreciation, cost segregation, and strategic property dispositions, you can generate substantial tax losses even when your properties are appreciating and cash-flowing. The key is understanding the rules that govern when and how you can use those losses.

How Real Estate Generates Tax Losses

Depreciation: The Foundation

Every rental property generates a paper loss through depreciation — even while the property is increasing in value. The IRS assumes buildings wear out over time:

• Residential rental property: 27.5 years
• Commercial property: 39 years

A $400,000 residential rental (building value only, excluding land) generates $14,545 per year in depreciation. If your rental income is $24,000 and your cash expenses are $16,000, your economic profit is $8,000 — but your taxable income is negative $6,545 after depreciation.

That $6,545 loss is a real tax deduction, even though you pocketed $8,000 in cash.

Accelerated Depreciation via Cost Segregation

Standard depreciation is helpful. Cost segregation makes it powerful. By reclassifying components of your property into 5, 7, and 15-year categories and applying [bonus depreciation](/blog/depreciation-rental-property-guide), you can generate first-year losses of $50,000-$200,000+ on a single property.

A $1 million apartment building might generate $29,000 in annual depreciation. After a cost segregation study with 20% bonus depreciation (2026 rate), that same property could generate $80,000-$120,000 in first-year depreciation deductions.

The excess over your rental income becomes a tax loss available to offset other income — subject to the passive activity rules.

Operating Losses

Beyond depreciation, real estate generates deductible expenses:

• Mortgage interest
• Property taxes
• Insurance
• Repairs and maintenance
• [[Property management](/blog/property-management-complete-guide) fees](/blog/property-management-fees-guide)
• Travel to properties
• Professional fees (CPA, attorney)

In years with large capital expenditures, vacancy, or major repairs, these [operating expenses](/blog/net-operating-income-guide) can push your rental activity into a significant loss position even before depreciation.

The Passive Activity Rules: Understanding the Gatekeeper

Here's where real estate tax-loss harvesting gets complicated. The IRS classifies rental income as passive, and passive losses can only offset passive income under IRC Section 469. This means your $100,000 rental loss can't automatically offset your $300,000 salary.

There are three main exceptions:

Exception 1: The $25,000 Active Participation Allowance

If you actively participate in managing your rental properties (approve tenants, set rents, authorize repairs), you can deduct up to $25,000 in rental losses against non-passive income.

But there's a catch: this allowance phases out for taxpayers with adjusted gross income (AGI) between $100,000 and $150,000. At $150,000 AGI, the allowance is zero. For most investors reading this article, this exception has limited utility.

Exception 2: [Real Estate Professional Status](/blog/real-estate-professional-status) (REPS)

If you or your spouse qualifies as a real estate professional (750+ hours in real property trades or businesses, more than 50% of total working time), your rental losses become non-passive. This unlocks unlimited deductions against any type of income.

REPS is the gold standard for tax-loss harvesting in real estate. Combined with cost segregation, REPS investors can generate and use six-figure annual losses against W-2, business, and investment income.

Exception 3: Full Disposition

When you sell a rental property in a fully taxable sale (not a [1031 exchange](/blog/1031-exchange-guide)), all suspended passive losses from that property are released and become deductible against any income. This is the "nuclear option" for unlocking trapped losses.

Strategic Loss Harvesting Techniques

Strategy 1: Stacking Cost Segregation Across Multiple Properties

Don't do cost segregation studies on all your properties at once (unless you can use all the losses). Instead, stagger them:

• Year 1: Cost seg on Property A → $80,000 loss
• Year 2: Cost seg on Property B → $75,000 loss
• Year 3: Cost seg on Property C → $90,000 loss

This creates a multi-year stream of large deductions. If you have REPS or can use the losses through other means, spreading the studies creates sustained tax reduction.

If you don't have REPS, the losses suspend and accumulate — but they're still valuable. They release when you sell (see Strategy 4).

Strategy 2: Offsetting Passive Income with Passive Losses

If you can't deduct rental losses against W-2 income, use them against other passive income:

• Other rental properties with positive income. Losses from one property offset gains from another.
• Passive business income. If you're a silent partner in a business, that income is passive and can be offset by rental losses.
• Gains from [selling rental property](/blog/selling-rental-property-guide). The gain from selling a rental is passive — your accumulated losses offset it.

Example: You have $60,000 in passive losses suspended from prior years. You sell a rental property with a $150,000 capital gain. The $60,000 in suspended losses offsets the gain, and you only pay tax on $90,000.

Strategy 3: Timing Gains and Losses

Just like stock investors, real estate investors can time dispositions to maximize tax efficiency:

• Sell a losing property in a year with big gains. If you're recognizing a large capital gain (from any source), selling a property with suspended losses converts those losses into active deductions.
• Delay sales to accumulate losses. If you know you'll sell a property in two years, do a cost segregation study now to maximize suspended losses before the sale.
• Accelerate losses before high-income years. Expecting a bonus, business sale, or other windfall? Front-load depreciation to have losses ready.

Strategy 4: Selling Property to Release Suspended Losses

This is the most powerful loss harvesting technique for non-REPS investors. When you sell a rental property in a fully taxable disposition, three things happen:

1. You recognize any capital gain or loss on the sale
2. All suspended passive losses from that property are released
3. The released losses offset the gain, then any excess offsets other income (passive or not)

Critical detail: This must be a complete disposition in a fully taxable transaction. A 1031 exchange does NOT release suspended losses — they carry over to the replacement property.

Example:

• Purchase price: $500,000
• Accumulated depreciation: $120,000
• Adjusted basis: $380,000
• Sale price: $550,000
• Gain on sale: $170,000 (including $120,000 [depreciation recapture](/blog/depreciation-real-estate-guide))
• Suspended passive losses: $95,000
• Net taxable gain: $75,000

Without the suspended losses, you'd pay tax on $170,000. The harvested losses saved you roughly $25,000-$35,000 in taxes.

Strategy 5: Partial Dispositions

The IRS allows partial dispositions of building components under the tangible property regulations. When you replace a roof, HVAC system, or other major component, you can "dispose" of the old component and claim its remaining undepreciated basis as a loss.

Example: Your commercial property's original roof (part of the building's depreciable basis) had a cost of $50,000 and $20,000 in accumulated depreciation. Adjusted basis: $30,000. When you replace the roof, you claim a $30,000 loss on the partial disposition — in addition to depreciating the new roof.

File Form 3115 to make the partial disposition election. This is a commonly overlooked strategy that generates additional losses without selling the property.

Strategy 6: Abandonment and Worthlessness

If a property becomes genuinely worthless — perhaps due to environmental contamination, structural failure, or permanent market decline — you may be able to claim an abandonment loss equal to your remaining adjusted basis.

This is rare and requires strong documentation, but it converts your remaining basis into an immediate deduction.

Building a Multi-Year Tax Loss Strategy

The most sophisticated investors don't just harvest losses opportunistically — they plan a multi-year strategy:

Year-by-Year Framework

Year 1 (Acquisition Year):

• Purchase properties
• Commission cost segregation studies
• Generate large first-year losses
• Determine if losses are usable (REPS) or will suspend

Years 2-5 (Holding Period):

• Continue standard depreciation
• Monitor suspended loss balances per property
• Perform cost seg on additional acquisitions
• Use partial dispositions when replacing major components
• Offset passive gains with passive losses

Years 5-10 (Optimization Period):

• Evaluate properties for disposition
• Time sales to coincide with high-income years
• Release suspended losses through strategic sales
• Consider 1031 exchanges for properties without significant suspended losses
• Sell properties with large suspended losses in taxable transactions

Ongoing:

• Track basis and suspended losses meticulously for every property
• Coordinate with CPA annually on loss utilization strategy
• Monitor legislative changes that might affect passive activity rules

Record-Keeping for Tax Loss Harvesting

Poor records destroy loss harvesting strategies. Track these for every property:

Per-Property Tracking

• Original cost basis (purchase price + closing costs + improvements)
• Accumulated depreciation (straight-line and accelerated components)
• Current adjusted basis (cost basis minus depreciation)
• Suspended passive losses (cumulative, from all sources)
• Capital improvements (date, amount, category)
• Partial dispositions claimed

Annual Tax Documentation

• Schedule E (rental income and expenses)
• Form 8582 (passive activity loss limitations)
• Form 4797 (sales of business property)
• Form 3115 (changes in accounting method, if applicable)
• Cost segregation study reports

Common Mistakes

1. Forgetting Suspended Losses When You Sell

Many investors (and some CPAs) forget to release suspended passive losses on property sales. These losses disappear if not claimed — they don't automatically show up on your return. Review Form 8582 carefully in any year you sell rental property.

2. 1031 Exchanging a Property with Large Suspended Losses

If you have $100,000 in suspended losses on a property and do a 1031 exchange, those losses remain suspended and transfer to the replacement property. You've delayed the tax benefit. Sometimes a taxable sale is smarter than an exchange.

3. Not Tracking Basis Property by Property

The IRS requires you to track suspended losses per activity (or per property if you haven't made a grouping election). Commingling your loss tracking makes it impossible to release losses correctly on a sale.

4. Missing Partial Disposition Opportunities

Every time you replace a major building component (roof, HVAC, plumbing, electrical panel, flooring), you have a partial disposition opportunity. Most investors never claim these, leaving thousands in deductions on the table.

5. Ignoring State Tax Implications

Some states don't conform to federal passive activity rules or have their own limitations. California, for example, has additional passive activity restrictions. Your federal and state loss harvesting strategies may need to differ.

Tax-Loss Harvesting and the Bigger Picture

Loss harvesting in real estate doesn't exist in a vacuum. It interacts with:

• Real estate professional status: Turns passive losses into active losses
• Cost segregation: Accelerates the creation of losses
• 1031 exchanges: Preserves gains but freezes suspended losses
• Opportunity zones: Alternative gain deferral when you do sell
• Estate planning: Step-up in basis at death eliminates all deferred depreciation recapture and resets the clock

The most tax-efficient real estate investors weave these strategies together into a cohesive plan — not just reacting to individual transactions.

Frequently Asked Questions

Can I carry forward suspended passive losses indefinitely?

Yes. Suspended passive losses carry forward indefinitely until you either generate passive income to offset them or dispose of the property in a fully taxable transaction. They never expire.

What's the difference between a capital loss and a passive loss?

Capital losses result from selling assets for less than your basis. Passive losses result from passive activities (like rental real estate) generating more deductions than income. They're governed by different rules — capital losses are limited to $3,000 per year against ordinary income, while passive losses have no dollar cap but can only offset passive income (unless exceptions apply).

Can I harvest losses on my primary residence?

No. Your primary residence is personal-use property, not investment property. Losses on the sale of a personal residence are not deductible. Only investment and business properties generate deductible losses.

Do I need to sell a property to benefit from tax losses?

No. Depreciation generates ongoing tax losses without selling. Cost segregation accelerates those losses. However, if your losses are suspended under passive activity rules, selling is the primary way to release them (unless you qualify for REPS or have passive income to offset).

How does tax-loss harvesting interact with depreciation recapture?

When you sell, depreciation recapture is taxed at 25% (Section 1250 gain). Your suspended passive losses first offset any gain on the sale, including the recapture portion. If your suspended losses exceed the total gain, the excess becomes deductible against other income.

Should I ever choose a 1031 exchange over releasing suspended losses?

It depends on the math. If the property has a large gain and small suspended losses, a 1031 exchange preserves more value. If the property has large suspended losses relative to the gain, a taxable sale that releases those losses may save more in total tax. Run both scenarios with your CPA.

The Bottom Line

Tax-loss harvesting in real estate goes far beyond selling losers to offset winners. It's a proactive, engineered approach that uses depreciation, cost segregation, strategic dispositions, and passive activity rules to systematically reduce your lifetime tax burden.

The investors who benefit most are those who plan ahead, track everything meticulously, and coordinate their property transactions with their overall tax strategy. Every property purchase, improvement, and sale is a tax event — treat it accordingly.

This article is for educational purposes only and does not constitute tax advice. Consult with a qualified tax professional before implementing any tax strategy.

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