The Rental Property You Already Own: Passive Losses, Depreciation and the Sale

A rental's tax story isn't written one year at a time. It's written over the whole time you own it, and most of the chapters that matter are decided before you sell.

Many high-income households own one rental property and never think of themselves as real estate investors. A condo bought before marriage. The first house, kept when the family moved. A unit near a university. Each year the rental income and expenses go onto Schedule E, a loss shows up that can't be used, and the property fades into the background of the return.

That's where the money gets lost. A single rental carries a set of rules that operate over years, and the decisions that matter most (when to sell, how to sell, what the property was before it was a rental) are rarely made with those rules in view.

Key points

• Above $150,000 of modified AGI, rental losses are generally suspended, not lost. They're released when the property is sold.

• Depreciation lowers tax each year, and the gain it creates is taxed at up to 25% federally at sale.

• A former home can keep up to $250,000 / $500,000 of gain tax-free if sold within the three-year window after you move out.

• Property taxes on a rental aren't subject to the SALT cap.

• California doesn't follow the federal real estate professional exception.

Why your rental loss doesn't reduce your tax

Rental activity is generally passive, and passive losses can offset only passive income. There's one exception for ordinary owners who take part in management decisions: up to $25,000 of rental loss can offset other income. But that allowance shrinks once modified AGI passes $100,000 and is gone at $150,000. Those figures aren't indexed for inflation, so most high-income households are above them.

The losses aren't lost. They're suspended, carried forward year after year, and released in full when you sell the property in a taxable sale to an unrelated buyer. A rental that showed losses for a decade can produce a large deduction in the year of sale. Choosing that year deliberately, ideally one with high other income, is part of the planning.

Two exceptions are worth knowing. A qualifying real estate professional can treat rental losses as non-passive, but the test (more than 750 hours a year and more than half your working time in real estate) rarely fits someone with a full-time career, and California doesn't follow it. Short-term rentals with an average stay of seven days or less fall under different rules, which can make losses usable when the owner materially participates.

Depreciation: a deduction now, partly repaid later

The building, not the land, is depreciated over 27.5 years. That deduction lowers taxable rental income every year, and often creates the suspended losses described above. At sale, the depreciation reduces your basis, and the gain attributable to it is taxed at up to 25% federally rather than at the lower capital gains rates. California taxes all of the gain as ordinary income.

One detail surprises people: basis is reduced by the depreciation you were entitled to take, whether or not you took it. A property where depreciation was skipped still carries the tax cost at sale, without the benefit along the way. If prior returns missed it, that can usually be corrected.

If the rental used to be your home

When you sell a home you've owned and lived in for at least two of the last five years, up to $250,000 of gain ($500,000 for joint filers) can be excluded. That rule still applies after you move out and rent the home, but only until the five-year window closes. In practice, a former home turned rental usually has about three years after you move out to be sold with the exclusion intact.

The exclusion doesn't cover the depreciation taken while it was rented; that portion is taxed. For many California homeowners sitting on large gains, the timing of a sale relative to that three-year window is the single largest decision about the property, and it's often made without anyone pointing it out.

The window to sell a former home with the exclusion closes quietly. Nothing on the return warns you it's coming.

Other items that add up

• Property taxes on a rental aren't subject to the SALT cap. They're deducted against rental income on Schedule E, separately from the property tax on your home.

• The 3.8% Net Investment Income Tax applies to net rental income and to the gain on sale once modified AGI exceeds $250,000 (joint) or $200,000 (single).

• Repairs versus improvements. Repairs are deducted in the year paid; improvements are added to basis and depreciated. The distinction affects both this year's deduction and the gain at sale, so records of what was done and when are worth keeping.

• A 1031 exchange defers the gain when you sell and buy replacement property. If the replacement is outside California, California still expects to tax the deferred California gain later and requires an annual filing to track it.

The engineer and the chess player

The engineer tracks the numbers that compound quietly over years: basis, depreciation, suspended losses and the dates that define the home-sale window. The chess player decides when those numbers should be cashed in. A sale in a high-income year releases suspended losses where they're worth the most. A sale inside the three-year window preserves the exclusion. A sale timed with a move out of state, or exchanged into a new property, changes which state taxes the gain. The right answer depends on what else is on the board that year and the years around it.

What to take from this

If you own a rental, the question isn't only how this year's Schedule E looks. It's what the property's full tax history adds up to, and which year, and which kind of sale, will produce the best result when you're ready to let it go. That's a multi-year question, and it deserves an answer well before a listing agreement is signed.

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Discuss your situation with Natalie C. Papagni, CPA

If you own a rental, the best time to plan its sale is well before a listing agreement is signed. A complimentary 30-minute consultation is the natural first step.

Natalie C. Papagni, CPA — Tax, Planning & Advisory Services 4275 Executive Square, Suite 200, La Jolla, CA 92037 (858) 754-8277 | service@lajollataxcpa.com | lajollataxcpa.com

Disclaimer: This material is provided for general educational purposes only. It is not tax, legal or accounting advice, and it does not create a CPA–client relationship. Tax outcomes depend on individual facts and circumstances, and figures and rules change from year to year. Consult a qualified professional about your specific situation before acting. Figures reflect 2026 federal and California rules.