Can Depreciation Offset Ordinary Income in Real Estate?

Depreciation from real estate can offset ordinary income, but only in specific situations. By default, rental depreciation creates a passive loss that can offset passive income and nothing else, meaning it won’t touch your wages, business profits, or portfolio gains. Three routes get around that: a limited $25,000 allowance for landlords under an income cap, qualifying as a real estate professional, or running a short-term rental that falls outside the rental activity definition entirely. Which one is available to you depends on your income, how much time you spend on real estate, and how long your guests stay.

Why Rental Depreciation Is Usually Blocked

Section 469 of the Internal Revenue Code sorts your income into three buckets: active (wages and profits from businesses you run), portfolio (dividends, interest, capital gains), and passive (rental activities and businesses where you don’t materially participate).¹ Rental real estate is treated as passive by default, no matter how many hours you spend on it.

The rule is simple. Passive losses can only offset passive income. When depreciation drives your rental into a paper loss and you have no other passive income to absorb it, the loss is suspended and carried forward until you either generate passive income in a later year or dispose of the property.¹ The suspended loss isn’t lost. It just can’t do the job most owners want it to do, which is knock down the tax on their salary.

Three exceptions change that outcome.

The $25,000 Allowance for Moderate Earners

Congress carved out a limited exception for smaller landlords who actively participate in their rentals. Active participation is a lower bar than material participation. It means making management decisions like approving tenants, setting rents, and authorizing repairs, even if a property manager handles the day-to-day work.

If you meet that standard and your adjusted gross income is $100,000 or less, you can deduct up to $25,000 of passive rental losses against ordinary income each year. The allowance shrinks by 50 cents for every dollar of AGI above $100,000 and disappears at $150,000.¹ A landlord with $120,000 in AGI has a maximum allowance of $15,000: $25,000 minus half of the $20,000 overage. At $150,000 you’re back to the general rule and every dollar of rental loss is suspended.

This works for someone with a couple of properties and a moderate salary. For higher earners it offers nothing, which is why the next two routes matter more.

Real Estate Professional Status

The most powerful way to offset ordinary income with real estate depreciation is qualifying as a real estate professional under Section 469(c)(7). This designation reclassifies your rental activities from passive to non-passive, removing the passive loss barrier for those activities. There is no income cap, so it’s the route high earners look at.

You have to clear two annual time-based tests. More than half of the personal services you perform across all trades and businesses during the year must be in real property trades or businesses where you materially participate, and you must log at least 750 hours in those real property activities. Real property trades or businesses include development, construction, acquisition, rental, management, and brokerage. Hours worked as a W-2 employee don’t count toward either test unless you own at least 5% of the employer.¹ That employee-hour rule is what prevents most full-time professionals from qualifying on their own.

On a joint return, only one spouse needs to meet the tests, but that spouse must qualify individually. Couples cannot combine hours.¹ This is the common setup: one spouse runs the real estate full-time, the other draws a paycheck, and the couple’s rental losses offset the wage-earner’s income on their joint return.

Material Participation in Each Property

REP status alone isn’t enough. You also need to materially participate in each rental activity generating the losses. The IRS recognizes seven material participation tests, the most commonly used being logging more than 500 hours in the activity during the year or performing substantially all the work yourself.² Hitting that on each individual property gets hard fast once you own more than one.

The fix is a grouping election that lets you treat all your rental real estate interests as a single activity, so your total hours across all properties count toward the 500-hour threshold.¹ You disclose the election on your tax return for the first year you make it, and it generally stays in effect for future years.

Documentation

The burden of proof on the 750-hour test and material participation falls on you. Tax Court cases consistently reject vague estimates and after-the-fact reconstructions. You need contemporaneous records: detailed logs, calendar entries, or appointment records showing the date, hours, and specific activities performed. Fail the documentation and your rental losses go back to being passive, with the IRS free to suspend them retroactively.

The Short-Term Rental Route

There is an alternative path that doesn’t require REP status. Under Treasury regulations, a property isn’t classified as a “rental activity” if the average guest stay is seven days or less.³ A second exception covers average stays of 30 days or less when you provide significant personal services such as daily cleaning, concierge services, or guided tours.

When a property falls outside the rental activity definition, it’s treated as a regular trade or business. If you materially participate in running it, and with a hands-on short-term rental 500 hours in a year is realistic, the losses are non-passive and can offset wages, business income, or any other ordinary income. This is why short-term rentals on platforms like Airbnb and Vrbo have become a common tax planning tool. You still need the material participation logs; the seven-day average alone doesn’t do the whole job.

How Much Can Actually Come Through

Once you’re on one of the three routes, the size of the offset comes down to how much depreciation you can generate.

Standard depreciation spreads a building’s cost over 27.5 years for residential rental property and 39 years for commercial.⁴ A cost segregation study compresses that timeline by having engineers reclassify components into shorter-lived categories:

5-year property: carpeting, countertops, cabinetry, specialty lighting, and dedicated electrical outlets
7-year property: office furniture and certain fixtures
15-year property: parking lots, landscaping, sidewalks, drainage systems, and fencing

You’re depreciating the same total cost, just faster. Bonus depreciation then amplifies the effect. Under the One Big Beautiful Bill Act signed in 2025, qualified property acquired after January 19, 2025 is eligible for a permanent 100% first-year depreciation deduction.⁵ The 5-, 7-, and 15-year components identified in a cost segregation study can be written off entirely in the year the property is placed in service. The building shell keeps its 27.5- or 39-year life. On a typical commercial property, 20% to 40% of total cost may qualify for reclassification and immediate write-off.

Combined with REP status or a qualifying short-term rental, this can produce six-figure paper losses in a single year against ordinary income. Without one of those classifications, the same deductions sit trapped by the passive activity rules.

The Excess Business Loss Cap

Even after clearing the passive activity hurdle, one more cap applies. Section 461(l) limits how much net business loss an individual can use against non-business income in a single year. For 2025 the threshold is $313,000 for single filers and $626,000 for joint filers, adjusted annually for inflation. Any business losses above the threshold become a net operating loss carried to future years rather than offsetting current-year wages or investment income. This cap rarely bites unless you’re acquiring multiple properties in the same year with cost segregation studies on each.

What Happens to Losses That Stay Passive

If none of the three routes apply to you, your rental depreciation losses aren’t gone. They accumulate as suspended passive losses and wait. Two things release them.

Any year you generate passive income from another source, whether from a profitable rental, a passive business investment, or a taxable gain from selling a different passive activity, your suspended losses offset that income dollar for dollar.

The bigger release comes on sale. When you dispose of your entire interest in a passive activity through a fully taxable sale to an unrelated party, all accumulated suspended losses from that activity are freed at once and can offset income from any source, including wages and portfolio income, with no limitation.¹ Selling to a family member delays the release until that person sells to a non-related buyer, and a 1031 exchange doesn’t trigger a release because the gain is deferred rather than recognized. An investor who accumulated $200,000 in suspended losses over a decade can apply all of them against ordinary income in the year of sale.

The Tradeoff: Depreciation Recapture

Depreciation isn’t free money. It’s a timing shift. Every dollar you claim reduces your property’s adjusted cost basis, which increases your taxable gain when you sell. The portion of your gain attributable to depreciation previously taken is taxed as unrecaptured Section 1250 gain at a maximum federal rate of 25%, higher than the 15% or 20% long-term capital gains rate that applies to the rest.

If you bought a property for $500,000, took $150,000 in depreciation, and sold for $600,000, your adjusted basis is $350,000 and your total gain is $250,000. The first $150,000 of that gain, matching the depreciation claimed, is taxed at up to 25%. The remaining $100,000 of appreciation is taxed at the preferential long-term capital gain rate. You saved taxes in the depreciation years at your marginal ordinary rate, which can run as high as 37%, and pay back at 25%, so the arithmetic usually favors taking the deduction. It is a deferral and a rate arbitrage, not a permanent escape.

1
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
2
Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules
3
eCFR. 26 CFR 1.469-1T – General Rules (Temporary)
4
Internal Revenue Service. Publication 946 – How to Depreciate Property
5
Internal Revenue Service. One, Big, Beautiful Bill Provisions