A Practical Tax Guide for Individual and Small Business Clients

By Jessica Irving Marschall, CPA, ISA AM

President and CEO, MAS LLC | The Green Mission Inc. | GM-ESG | Probity Appraisal Group

April 2026

Introduction

Real estate has long served as one of the most powerful wealth-building vehicles available to individual investors and small business owners. The combination of passive income, appreciation potential, depreciation deductions, and favorable capital gains treatment makes investment property uniquely attractive within the US IRC tax code. However, the rules governing how real estate income, losses, and gains are treated are among the most complex in the Internal Revenue Code, and the consequences of misunderstanding them can be severe.

This guide addresses the three questions I hear most frequently from clients who own or are considering investment property: How will my rental income and losses be classified for tax purposes? How do I qualify as a Real Estate Professional and why does it matter? And should I hold each property in a separate Limited Liability Company? A final section addresses the often-overlooked subject of suspended passive losses and the critical planning implications that arise at the time of sale or at death.

The analysis that follows is grounded in the Internal Revenue Code, Treasury Regulations, and IRS guidance, as well as current professional commentary. As with all tax matters, individual circumstances govern, and clients are encouraged to work directly with their tax advisor to apply these principles to their specific situations.

I. Active vs. Passive Income: The Foundation of Real Estate Taxation

A. The Passive Activity Rules Under IRC Section 469

The passive activity rules, codified within Internal Revenue Code Section 469, were enacted as part of the Tax Reform Act of 1986. Their purpose was to limit the ability of high-income taxpayers to use losses from investments in which they played little or no active role to offset ordinary income such as wages, salaries, and business profits. Congress recognized that real estate in particular had become a vehicle for tax shelter abuse, and the 1986 legislation fundamentally changed the landscape for real estate investors.

Under Section 469, a passive activity is any trade or business in which the taxpayer does not materially participate, as well as any rental activity, regardless of whether the taxpayer materially participates. This second prong is critical: rental activities are presumptively passive. The statute creates this presumption because Congress determined that collecting rent is fundamentally a passive act, even when the landlord is actively involved in managing the property.

The fundamental rule is straightforward: losses from passive activities may only offset income from other passive activities. Passive losses that exceed passive income cannot be deducted against ordinary income in the current year. They are instead suspended and carried forward to future tax years. Those suspended losses become deductible when the taxpayer generates sufficient passive income in a future year, or when the taxpayer disposes of the passive activity in a fully taxable transaction.

B. What Constitutes Active Participation

Congress recognized that a blanket prohibition on deducting rental losses would be unduly harsh for small landlords who are genuinely engaged in managing their properties. Accordingly, IRC Section 469(i) carves out a limited exception for taxpayers who actively participate in a rental real estate activity.

Active participation is a lower threshold than material participation. It does not require that the taxpayer personally perform the day-to-day work of managing the property. Rather, it requires that the taxpayer make bona fide management decisions in a significant and genuine sense. Approving new tenants, deciding on rental terms, authorizing repairs, and determining rental conditions all qualify as active participation. A taxpayer who hires a property manager but retains authority over major decisions will generally satisfy this standard.

If a taxpayer actively participates in a rental real estate activity, IRC Section 469(i) permits the deduction of up to $25,000 of rental losses against ordinary income each year. This $25,000 allowance is, however, subject to a phase-out based on the taxpayer’s Modified Adjusted Gross Income (MAGI). As summarized in the table below, the allowance is reduced by 50 cents for every dollar of MAGI above $100,000, and it is completely eliminated once MAGI reaches $150,000.

MAGI Range	Passive Loss Allowance	Investor Status
Below $100,000	Full $25,000	Optimal Zone
$100,000 to $150,000	Reduced: $0.50 per $1.00 over $100,000	Phase-Out Zone
Above $150,000	$0 (unless Real Estate Professional)	Fully Eliminated

Example: A taxpayer with MAGI of $130,000 and $20,000 in rental losses may deduct only $10,000 of those losses currently (because the $30,000 excess over $100,000 eliminates $15,000 of the allowance, leaving $10,000 of the $25,000 cap available). The remaining $10,000 is suspended and carried forward.

It is also important to note that the active participation exception is generally available only to individuals, qualifying estates, and certain trusts (such as qualified revocable trusts electing to be treated as part of the decedent’s estate). Limited partners and similarly passive investors are generally not treated as actively participating and are therefore subject to the full passive loss limitations without access to the $25,000 offset.

C. Material Participation: The Higher Standard

Material participation is a stricter standard than active participation and is the basis for treating a rental or business activity as non-passive. Treasury Regulation Section 1.469-5T sets forth seven tests for material participation, any one of which will suffice:

• The taxpayer participates in the activity for more than 500 hours during the year.
• The taxpayer’s participation constitutes substantially all of the participation in the activity for the year.
• The taxpayer participates for more than 100 hours, and that participation is not less than any other individual’s participation.
• The activity is a “significant participation activity,” and the taxpayer’s aggregate participation in all significant participation activities exceeds 500 hours.
• The taxpayer materially participated in the activity for any five of the ten preceding taxable years.
• The activity is a personal service activity in which the taxpayer materially participated for any three preceding taxable years.
• Based on all the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.

For most rental real estate investors, satisfying material participation alone is not sufficient to make rental income and losses non-passive. The special rules for Real Estate Professionals, discussed at length in Section II below, provide the pathway to treating rental activities as active rather than passive.

D. Portfolio Income: The Third Category

In addition to active income and passive income, the tax code recognizes a third category: portfolio income. Portfolio income includes interest, dividends, annuities, royalties, and gains from the sale of investment assets. It is critical for real estate investors to understand that portfolio income is not passive income. Passive losses cannot be used to offset portfolio income, even if the taxpayer has more than enough passive losses to absorb it.

This distinction matters because some clients mistakenly believe that losses from their rental properties can offset dividend income or interest income from their investment accounts. They cannot. Portfolio income remains in its own silo, and passive losses may only offset income that is genuinely passive in character.

E. Net Investment Income Tax Considerations

The Net Investment Income Tax (NIIT) of 3.8%, imposed by IRC Section 1411, applies to the lesser of a taxpayer’s net investment income or the excess of MAGI over certain threshold amounts ($200,000 for single filers; $250,000 for married filing jointly). Rental income from activities in which the taxpayer does not materially participate is generally subject to the NIIT. Taxpayers who qualify as Real Estate Professionals and materially participate in their rental activities may be able to exclude that rental income from the NIIT base, which represents a significant additional benefit beyond the passive loss rules.

II. Real Estate Professional Status: A Detailed Analysis

A. Overview and Significance

Qualifying as a Real Estate Professional (REP) under IRC Section 469(c)(7) is the single most powerful tax planning strategy available to taxpayers who own substantial rental real estate. A taxpayer who meets the REP requirements may treat rental activities in which the taxpayer materially participates as non-passive, meaning that losses from those activities can be deducted against any type of income, including wages, business income, and portfolio income, without limitation.

Consider the practical impact: a physician with $400,000 in wages and a spouse who manages the couple’s rental properties full-time. If the spouse qualifies as a Real Estate Professional, the couple may use rental losses from depreciation and other deductions to offset the physician’s $400,000 in ordinary income. Without REP status, those same losses would be trapped as passive losses, generating little or no current tax benefit for a household earning above $150,000. Over time, the value of this planning can be transformative.

However, REP status is a high bar. The IRS scrutinizes REP claims carefully, and taxpayers who claim the status without satisfying both prongs of the statutory test face significant audit risk, potential accuracy-related penalties, and the disallowance of substantial deductions. A disciplined approach to qualification, documentation, and recordkeeping is essential.

B. The Two-Part Statutory Test

IRC Section 469(c)(7)(B) imposes two requirements that must both be satisfied in each tax year for which REP status is claimed.

1. The More-Than-50-Percent Test

More than 50 percent of the personal services the taxpayer performs during the year must be performed in real property trades or businesses in which the taxpayer materially participates. This test is sometimes called the “majority of services” test, and it is fundamentally about ensuring that real estate is the taxpayer’s primary professional activity.

A “real property trade or business” is defined in Section 469(c)(7)(C) to include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. This definition is broad and encompasses most activities associated with owning, developing, and managing real estate.

The critical implication of this test is that a taxpayer who has a full-time W-2 job outside of real estate will almost never satisfy it. If a software engineer with a 2,000-hour work year also spends 800 hours managing rental properties, only 29 percent of total services are devoted to real estate, well short of the 50-percent threshold. This is why REP status is most commonly claimed by taxpayers who are full-time real estate brokers, property managers, developers, or by a spouse who devotes the majority of working hours to managing the couple’s portfolio.

2. The 750-Hour Test

The taxpayer must perform more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates. This is an absolute floor, not a target. Even if 100 percent of a taxpayer’s services are in real estate, fewer than 750 hours is insufficient.

It is important to note that 750 hours is a relatively modest threshold for a taxpayer who is genuinely engaged full-time in real estate. A full-time practitioner working 40 hours per week for 50 weeks would log 2,000 hours, more than adequate. The more common problem is ensuring that the hours are properly documented, allocated between qualified real estate activities and non-qualifying activities, and contemporaneously recorded in a manner that will survive IRS scrutiny.

C. Material Participation at the Property Level

Satisfying the two-part REP test is a prerequisite for treating rental activities as non-passive. However, it is not sufficient on its own. A taxpayer who qualifies as a Real Estate Professional must also materially participate in each individual rental activity in order for losses from that activity to be treated as non-passive. The material participation standards of Treasury Regulation Section 1.469-5T (the seven tests described in Section I.C above) apply to each rental property separately.

This creates a significant practical challenge for taxpayers who own multiple properties. A taxpayer who qualifies as a REP but employs a property manager for all of the rental properties may struggle to demonstrate material participation in each property individually, particularly if the portfolio is large. For a taxpayer with 15 properties, demonstrating more than 100 hours of participation in each individual property would require a minimum of 1,500 hours per year devoted specifically to participation testing at the property level.

D. The Grouping Election: A Powerful Planning Tool

IRC Section 469(c)(7)(A) provides a solution to the individual property participation problem: the grouping election. A taxpayer who qualifies as a Real Estate Professional may elect to treat all of the taxpayer’s rental real estate activities as a single activity for purposes of the material participation test. If the grouping election is made, the taxpayer need only demonstrate material participation in the combined rental activity as a whole, rather than in each individual property.

The grouping election is generally made by attaching a statement to the taxpayer’s original timely filed return (including extensions) for the first year in which the election is effective. Once made, the election is binding in subsequent years unless the facts and circumstances change in a manner that renders the original grouping clearly inappropriate. While the election is typically made on a timely filed original return, late-election relief may be available in limited circumstances under applicable IRS guidance.

The grouping election should be part of every initial REP planning engagement. A taxpayer with a large portfolio who fails to make the election may find it exceedingly difficult to demonstrate material participation on a property-by-property basis, undermining the value of REP status even if both prongs of the two-part test are satisfied.

E. Married Taxpayers: Allocation of Hours

For married taxpayers filing a joint return, IRC Section 469(c)(7)(B) requires that each spouse be evaluated individually for REP qualification. The statute explicitly provides that the more-than-50-percent test and the 750-hour test must be satisfied by one spouse alone; hours performed by both spouses cannot be combined to satisfy either requirement.

This rule has important planning implications for couples where one spouse works in real estate and the other does not. In the classic planning scenario, a high-income spouse in another profession (medicine, law, finance) and a spouse who manages the family’s real estate portfolio full-time can achieve REP status through the real estate spouse alone, providing access to substantial current deductions against the working spouse’s ordinary income.

However, both spouses must take care in structuring ownership and documentation. The real estate spouse should hold formal management roles in all entities that own rental property, and hours must be documented individually rather than attributed jointly.

F. Documentation: The Standard That Wins and Loses Audits

The Tax Court has consistently ruled that vague, reconstructed, or unsupported time logs are insufficient to substantiate Real Estate Professional status. While the regulations permit taxpayers to establish participation through any reasonable means, in practice, contemporaneous records provide the strongest support and are significantly more likely to withstand IRS scrutiny.

Recommended documentation practices include the following. A daily or weekly time log should record the date, the specific property or activity involved, the nature of the work performed, and the duration in hours and minutes. Corroborating documentation such as vendor invoices, contractor communications, tenant correspondence, property inspection reports, and mileage logs should be retained and cross-referenced to the time log. The time log should be prepared in a manner that clearly distinguishes qualifying real property activities from non-qualifying activities such as administrative work for other businesses, personal financial management, or education.

Taxpayers who claim REP status year after year while maintaining W-2 employment in an unrelated field face a structurally difficult audit position. If the W-2 hours alone exceed the real estate hours, the 50-percent test cannot be satisfied regardless of how many hours are logged in real estate. Those taxpayers should work with their advisors to conduct an honest pre-filing assessment of whether REP status is actually supportable.

G. The REP Status Summary Table

Requirement	Standard
More than 50% of personal services	Must be in real property trades or businesses in which taxpayer materially participates
Minimum annual hours	More than 750 hours during the tax year
Material participation per property	At least one of the seven IRS tests must be satisfied for each rental activity
Grouping election available	IRC Section 469(c)(7)(A) permits grouping all rental activities as a single activity
Married couples filing jointly	Only one spouse need qualify; hours are not combined between spouses

III. Entity Structure: Should Each Property Have Its Own LLC?

A. The Core Purpose of the LLC in Real Estate

The Limited Liability Company has become the dominant vehicle for holding investment real estate in the United States, and for good reason. The LLC combines the liability protection of a corporation with the tax simplicity of a partnership or sole proprietorship. Income and losses flow through to the owners’ personal returns, avoiding corporate-level taxation, while the members’ personal assets are shielded from claims arising within the LLC.

The LLC’s liability protection is not absolute. Courts will “pierce the corporate veil” and hold members personally liable when the LLC is used as a mere alter ego, when members commingle personal and business funds, when the LLC is inadequately capitalized, or when other formalities of separate entity status are not respected. Proper formation, an executed operating agreement, a dedicated business bank account, and meticulous separation of entity and personal finances are non-negotiable conditions for maintaining the protection the LLC is designed to provide.

B. The Case for Holding Each Property in Its Own LLC

The most protective approach, from a liability standpoint, is to place each investment property in a separate LLC. The strategic rationale is asset segregation: if a tenant, contractor, or third party obtains a judgment against one property, the equity in other properties is insulated because it belongs to entirely separate legal entities. Without this segregation, a plaintiff who obtains a judgment against an LLC that holds ten properties can potentially reach the equity in all ten.

Consider a concrete illustration. An investor owns four rental properties, all held within a single LLC. A tenant at Property #1 suffers a serious injury due to a defect in a common area and obtains a judgment of $800,000. The investor carries only $500,000 in general liability insurance, leaving a $300,000 excess. Because all four properties are in the same LLC, the plaintiff may seek to satisfy the $300,000 deficiency from the equity of Properties #2, #3, and #4. Had each property been isolated in its own LLC, that exposure would not exist.

Beyond liability isolation, separate LLCs also facilitate targeted ownership structures, enable property-specific financing arrangements, simplify exit planning when a single property is sold or contributed to a joint venture, and allow for distinct ownership percentages among partners who may have interests in some but not all properties.

For properties located in different states, separate LLC formation in each state is often advisable both for compliance purposes and to avoid complications arising from foreign registration requirements. Properties in different jurisdictions are also subject to distinct landlord-tenant laws, eviction procedures, and liability environments, making segregation particularly prudent.

C. The Case for Consolidation: When a Single LLC May Be Appropriate

The one-property-per-LLC approach is not always optimal. Formation and maintenance costs, while modest in many states, accumulate when multiplied across a large portfolio. Most states charge annual registration or report fees. An investor with twenty properties in twenty separate LLCs faces twenty annual filings, twenty separate bank accounts, twenty sets of books, and potentially twenty separate tax returns if the LLCs are not treated as disregarded entities or consolidated for reporting purposes.

For investors with low-equity properties where the litigation exposure is modest relative to the administrative burden, consolidation may be reasonable. Properties of similar type and risk profile held within a single state can reasonably share an LLC, provided that the investor maintains robust insurance coverage and understands that the liability firewall exists only at the LLC boundary, not between individual properties within the LLC.

Mark J. Kohler, CPA and attorney, offers a useful illustration of the dangers at both extremes: a client with 42 properties consolidated in a single Arizona LLC holding over $2 million in equity, and a separate client with 4 modest properties in 4 separate Nevada LLCs while residing in California. Both structures required correction. Optimal structuring lives between those extremes, calibrated to the equity at risk, property type, geographic distribution, and the investor’s capacity to maintain proper entity formalities.

D. The Series LLC: An Alternative for Multi-Property Investors

A number of states, including Delaware, Texas, Nevada, Wyoming, and Illinois, permit the formation of a Series LLC. A Series LLC is a single legal entity that contains separate “series” or cells, each of which may hold its own assets, liabilities, and members. In theory, each series within the master LLC is insulated from the liabilities of other series, providing a level of liability segregation similar to owning multiple standalone LLCs at a significantly lower administrative cost.

The Series LLC is an attractive concept, but it carries meaningful limitations. The legal enforceability of inter-series liability protection has not been tested in every jurisdiction, particularly in states that do not recognize the Series LLC structure. If a property held in a Delaware Series LLC is litigated in a jurisdiction that does not recognize series insulation, the protection may not hold. For investors whose properties are concentrated in states with well-developed Series LLC jurisprudence, the structure warrants serious consideration. For those with geographically diverse portfolios, individual LLCs may continue to be the safer choice.

E. Financing Considerations

One practical constraint on LLC ownership that every investor must confront is the financing market’s treatment of property held in an LLC. Residential mortgage lenders operating under Fannie Mae and Freddie Mac guidelines generally will not extend conventional financing to LLCs. Investors who wish to obtain conventional 30-year financing typically must take title in their individual names. Commercial lenders and portfolio lenders are more accommodating of LLC ownership, but interest rates and loan terms are generally less favorable than for individual borrowers.

Additionally, transferring a property into an LLC after purchase may trigger a “due-on-sale” clause in the existing mortgage, giving the lender the right to demand immediate repayment. While certain transfers (such as those to revocable trusts) may qualify for protection under the Garn-St. Germain Depository Institutions Act of 1982, transfers to LLCs are more fact-specific and are not universally protected. Investors should consult with both their lender and legal counsel before transferring mortgaged property into an LLC.

F. Practical Summary: A Decision Framework

A thoughtful LLC structuring decision should account for the following factors, in approximate order of priority:

• The equity at risk in each property: Properties with substantial equity warrant stronger isolation.
• The liability environment: Short-term rentals, properties with pools or other attractive nuisances, and multi-family residential properties carry higher litigation exposure than long-term single-tenant commercial leases.
• Geographic distribution: Properties in different states generally benefit from separate LLCs.
• Financing structure: Properties encumbered with conventional mortgages may need to remain in individual names until refinanced.
• Insurance coverage: Comprehensive umbrella liability policies reduce but do not eliminate the need for structural protection.
• Administrative capacity: The investor’s willingness and ability to maintain separate entity formalities for each LLC.

There is no universal answer. The appropriate structure is the product of a collaborative analysis between the investor, the tax advisor, and qualified legal counsel.

IV. Suspended Passive Losses: Mechanics, Strategies, and Estate Planning Traps

A. How Suspended Losses Accumulate

When a rental property generates losses in excess of the passive income available to absorb them (subject to the $25,000 active participation allowance, which phases out entirely for taxpayers with MAGI above $150,000), those losses are not lost. They are suspended: carried forward indefinitely on Schedule E and tracked on Form 8582 (Passive Activity Loss Limitations). They accumulate year after year, and for a property held over a decade, suspended losses of $100,000 to $300,000 or more are common, driven primarily by depreciation deductions that generate paper losses even when the property produces positive cash flow.

For many of my clients who are successful professionals, the $150,000 MAGI threshold eliminates the $25,000 active participation allowance, meaning that every dollar of rental loss is suspended unless and until they qualify as Real Estate Professionals. The suspended losses represent a future tax asset, a deferred benefit waiting to be unlocked under the right circumstances.

B. When Suspended Losses Are Released: A Full Disposition

Under IRC Section 469(g)(1), all suspended passive losses attributable to a passive activity are released in full when the taxpayer disposes of the entire interest in that activity in a fully taxable transaction to an unrelated party. The release at disposition is complete and unconditional: every dollar of suspended loss from that activity, accumulated across all prior years, becomes deductible in the year of sale.

The mechanics of the deduction at disposition are important to understand correctly. In the year of disposition, the taxpayer first computes the gain or loss on the sale. The suspended losses are then added to any current-year passive losses and deducted against income in the following sequence: first against net passive income from other activities, then against any net gain recognized on the disposition, and finally against any remaining ordinary income. In other words, a taxpayer who sells a passive rental property at a gain may use accumulated suspended losses to offset that gain and potentially create a net deductible loss against other ordinary income in the same year.

Example: An investor sells a rental property in a fully taxable sale, recognizing a $120,000 capital gain. The investor has $90,000 in suspended passive losses accumulated from that property. The $90,000 is released and first offsets passive income, then the $120,000 gain. The investor’s net position is a $30,000 taxable gain rather than $120,000, representing a meaningful reduction in the tax liability on the sale.

C. Partial Dispositions and Related Party Sales

The full release of suspended losses is conditioned on the disposition being complete and to an unrelated third party in a taxable transaction. A partial disposition releases only a proportionate share of the suspended losses. A disposition to a related party (as defined under IRC Section 267 and 707) does not trigger the release at all; the losses remain suspended until the related party disposes of the interest in a transaction with an unrelated third party.

Similarly, a non-recognition transaction such as a Section 1031 like-kind exchange does not trigger the release of suspended losses. When a property is exchanged into a replacement property under Section 1031, the suspended losses from the relinquished property carry over to the replacement property and remain suspended until that property is eventually sold in a taxable transaction. This is an important planning consideration for investors who are contemplating a 1031 exchange: they are not sacrificing their suspended losses, but they are deferring access to them.

D. The Estate Planning Trap: Death and the Step-Up in Basis

Perhaps the most consequential and least understood aspect of suspended passive losses is what happens to them when a property owner dies without having sold the property. This is a planning trap that I encounter regularly, and the stakes are high.

When an individual dies holding appreciated property, IRC Section 1014 provides that the property receives a step-up in basis to its fair market value as of the date of death. The step-up eliminates any built-in gain in the property: heirs who sell immediately after inheriting pay no capital gains tax on appreciation that accrued during the decedent’s lifetime. This is one of the most powerful tax benefits in the entire Code and is a cornerstone of generational wealth planning.

However, the step-up in basis under Section 1014 has a devastating interaction with suspended passive losses. Under IRC Section 469(g)(2), when a taxpayer dies holding passive activities with suspended losses, those losses are permanently and irrevocably forfeited to the extent that they do not exceed the step-up in basis. To be precise: the suspended losses are reduced (and potentially eliminated entirely) by the amount by which the property’s fair market value at death exceeds its adjusted basis. Only the excess of the suspended losses over the step-up amount, if any, carries over to the decedent’s final income tax return. Any suspended passive losses that exceed the step-up in basis may be deductible on the decedent’s final income tax return, though in many practical scenarios the step-up fully eliminates the suspended loss carryforward

An investor who accumulates $200,000 in suspended passive losses over twenty years of holding a rental property, and who then dies with a property that has appreciated by $300,000 above adjusted basis, loses the entire $200,000 in suspended losses. The step-up eliminates them in their entirety. The heirs receive a stepped-up basis and pay no capital gains tax, but the $200,000 deduction that the investor spent decades building is permanently gone. Neither the decedent’s estate nor the heirs can claim it.

This is a planning urgency, not merely a planning consideration. Clients who are aging, in declining health, or who are simply unlikely to sell their rental properties during their lifetimes should work with their advisors to evaluate whether it makes more sense to sell appreciated properties while living, triggering a taxable gain that can be offset by the released suspended losses, or to hold for the stepped-up basis, forfeiting the suspended losses but eliminating the capital gains tax for heirs. The right answer depends on the relative size of the suspended losses, the amount of appreciation, the owner’s marginal tax rate, the heirs’ expected holding period, and a host of other factors. The point is that inaction is a choice with significant tax consequences.

E. Illustrative Comparison: Sale vs. Hold-to-Death

The following comparison illustrates the trade-off:

• Investor holds a rental property for 20 years. Adjusted basis after depreciation: $150,000. Fair market value: $500,000. Suspended passive losses: $180,000.
• Scenario A (Sale During Life): Investor sells for $500,000. Gain of $350,000. Suspended losses of $180,000 are released and offset the gain, reducing net recognized gain to $170,000. Applicable capital gains tax plus depreciation recapture is computed on $170,000. The $180,000 in suspended losses is fully utilized.
• Scenario B (Hold to Death): Investor dies holding the property. Heirs receive a stepped-up basis of $500,000. Heirs owe no capital gains tax if they sell immediately. However, the $180,000 in suspended losses is eliminated: the step-up exceeds the suspended losses, and the losses are permanently forfeited. The investor’s estate derives no benefit from two decades of accumulated deductions.

Which scenario is better depends on the numbers. The planning imperative is to model both outcomes before it is too late to choose.

F. Strategies to Manage Suspended Losses

Several strategies are available to taxpayers who have accumulated significant suspended losses and wish to unlock them:

1. Qualify as a Real Estate Professional. If the taxpayer can satisfy both prongs of the REP test, all rental activities in which the taxpayer materially participates become non-passive, and previously suspended losses are released immediately. This is the most powerful single strategy for high-income real estate investors.
2. Sell the property in a fully taxable transaction. A complete, arm’s-length sale releases all suspended losses from that property in the year of sale, even if the sale results in a gain. Timing the sale to coincide with other planning objectives, such as retirement, portfolio rebalancing, or estate planning, can maximize the value of the release.
3. Generate passive income from other sources. Acquiring properties that produce consistent positive cash flow, investing in passive activities through limited partnerships, or investing in certain real estate investment vehicles can create passive income to absorb suspended losses year by year.
4. Installment sales with passive income generation. A taxpayer who sells a passive property on an installment basis recognizes gain (and triggers the suspended loss release) over multiple years. While the full suspended loss is released in the year of disposition under Section 469(g), the installment structure may assist in managing the overall tax exposure by spreading the recognition of gain.
5. Planning within the estate. A charitable remainder trust, a grantor retained annuity trust, or an installment sale to heirs can sometimes create transactions that release suspended losses while meeting broader wealth transfer objectives. These structures are complex and require coordinated legal, tax, and financial planning.

V. Conclusion

Real estate investment offers extraordinary tax-planning opportunities, but those opportunities are embedded within a complex statutory and regulatory framework that demands careful, proactive management. The passive activity rules of IRC Section 469 determine whether your rental losses are usable today or deferred indefinitely. Real Estate Professional status can fundamentally transform your tax position, but only if you satisfy both statutory requirements, document your hours rigorously, and structure your activities to support material participation. The decision of whether to hold each property in a separate LLC is not a one-size-fits-all matter; it is a function of equity at risk, liability exposure, geography, financing constraints, and your capacity to maintain proper entity formalities.

Most critically, the interaction between suspended passive losses, the step-up in basis at death, and the permanent forfeiture rule of IRC Section 469(g)(2) represents one of the most consequential and least visible planning traps in the tax code. Every client who holds appreciated rental property with accumulated suspended losses should model the comparative outcomes of a lifetime sale versus a hold-to-death strategy. The cost of inaction can be the permanent loss of decades of deferred deductions.

Tax law in this area is not static. Legislative and regulatory changes, including potential modifications to the step-up in basis rules that have been periodically proposed in Congress, can alter the analysis materially. Clients are encouraged to revisit these strategies annually with their tax advisor, particularly in years when income patterns, portfolio composition, or family circumstances change.

As always, the guidance contained in this article is educational in nature. The application of these rules to any specific taxpayer’s situation requires individualized analysis. I encourage clients and colleagues with questions to reach out directly for a consultation.

Bibliography and Source References

The following sources were consulted in the preparation of this article. All IRS publications, code sections, and Treasury Regulations cited herein are authoritative primary sources. Secondary sources are identified as such.

Primary Legal and Regulatory Authority

1. Internal Revenue Code Section 469: Passive Activity Losses and Credits Limited. 26 U.S.C. § 469. Governs passive activity loss limitations, real estate professional status, material participation, and disposition rules.

2. Internal Revenue Code Section 469(c)(7): Special Rule for Taxpayers in Real Property Business. Defines the two-part test for Real Estate Professional qualification.

3. Internal Revenue Code Section 469(g): Dispositions of Entire Interest in Passive Activity. Governs the release and forfeiture of suspended passive losses upon disposition, including at death.

4. Internal Revenue Code Section 469(i): $25,000 Offset for Rental Real Estate Activities. Sets forth the active participation allowance and the MAGI phase-out schedule.

5. Internal Revenue Code Section 1014: Basis of Property Acquired from a Decedent. Establishes the step-up in basis rules applicable at death.

6. Internal Revenue Code Section 1411: Imposition of Tax (Net Investment Income Tax). 26 U.S.C. § 1411. Governs the 3.8% surtax on net investment income.

7. Treasury Regulation Section 1.469-5T: Material Participation (Temporary). 26 C.F.R. § 1.469-5T. Sets forth the seven tests for material participation.

8. Internal Revenue Service. Publication 925: Passive Activity and At-Risk Rules (2024). Washington, D.C.: Department of the Treasury. Available at: https://www.irs.gov/publications/p925

9. Internal Revenue Service. Licensed Real Estate Agents: Real Estate Tax Tips. Small Businesses and Self-Employed. Available at: https://www.irs.gov/businesses/small-businesses-self-employed/licensed-real-estate-agents-real-estate-tax-tips

Professional and Advisory Commentary

10. EisnerAmper. “Are You a Real Estate Professional?” Tax Insights. September 2022. Available at: https://www.eisneramper.com/insights/tax/tax-real-estate-professional-tax-0922/

11. Cherry Bekaert (CBH). “Real Estate Professional Status: Requirements and Tax Benefits.” Insights and Articles. Available at: https://www.cbh.com/insights/articles/real-estate-professional-status-reps-tax-benefits/

12. Uncle Kam Advisors. “Suspended Passive Losses for Real Estate Investors: 2026 Tax Strategy Guide.” January 10, 2026. Available at: https://unclekam.com/tax-strategy-blog/suspended-passive-losses/

13. Mercer Advisors. “The Perils of Suspended Losses.” Tax and Wealth Insights. Available at: https://www.merceradvisors.com/insights/taxes/the-perils-of-suspended-losses/

14. Kohler, Mark J., CPA. “How Many Properties Should I Put in My LLC?” Mark J. Kohler Blog. November 26, 2024. Available at: https://markjkohler.com/blog/how-many-properties-should-i-put-in-my-llc

15. NCI Inc. “Should You Form a Separate LLC for Each Real Estate Investment?” Business Startup Blog. Available at: https://nchinc.com/blog/business-startup/should-you-form-a-separate-llc-for-each-real-estate-investment/

16. Lane, Lane & Kelly, LLP. “The Advantages and Disadvantages of Holding an Investment Property in an LLC.” Legal Blog. Matthew B. Lane, December 11, 2025. Available at: https://llklaw.com/legal-blog/the-advantages-and-disadvantages-of-holding-an-investment-property-in-an-llc

17. Julius Baer. “Building Your Real Estate Portfolio: What Are the Options?” Wealth Insights. Available at: https://www.juliusbaer.com/es/carrera/our-people/wealth-insights/bienes-inmuebles/building-your-real-estate-portfolio-what-are-the-options/

Case Law and Related Authority

18. Moss v. Commissioner, T.C. Memo 2017-29. United States Tax Court. Illustrates IRS scrutiny of Real Estate Professional hour documentation and the requirement for contemporaneous records.

19. Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016). Federal appellate decision addressing material participation documentation requirements for Real Estate Professional status claims.

20. Garn-St. Germain Depository Institutions Act of 1982, 12 U.S.C. § 1701j-3. Federal statute governing “due-on-sale” clause enforceability and exceptions applicable to certain property transfers into LLCs or trusts.

This article is intended for educational and informational purposes only. It does not constitute legal, investment, or tax advice specific to any individual. Readers should consult with a qualified tax professional, attorney, and financial advisor regarding their specific circumstances.

Copyright 2026 MAS LLC | Jessica Irving Marschall, CPA, ISA AM. All rights reserved.