Real Estate and Taxes: 1031 Exchanges, Cost Segregation, and Passive Losses

Real estate investors have three primary tax tools in 2026. A 1031 exchange defers capital gains and depreciation recapture when one investment property is swapped for another, subject to strict 45-day and 180-day deadlines. Cost segregation accelerates depreciation, and with 100 percent bonus depreciation made permanent by the One Big Beautiful Bill Act for property acquired and placed in service after January 19, 2025, a large share of a building's cost can be deducted in year one. Whether those losses are usable depends on the passive activity rules, including real estate professional status.

How does a 1031 exchange work?

Section 1031 lets you sell investment or business real estate and reinvest in other real estate without recognizing gain. Since the Tax Cuts and Jobs Act, only real property qualifies; equipment and other personal property do not. The deferral covers both the capital gain and the accumulated depreciation recapture, which is taxed at up to 25 percent when recognized.

The mechanics are unforgiving. Sale proceeds must go to a qualified intermediary, never to you; touching the cash kills the exchange. You have 45 days from closing to identify replacement property in writing and 180 days to close on it, with no extensions for weekends or holidays. To defer all gain, the replacement must be of equal or greater value and equity; any cash or debt reduction you take out is "boot" and is taxable. Your old basis carries into the new property, so the tax is deferred, not erased.

What is cost segregation, and how does bonus depreciation amplify it?

A commercial building is normally depreciated over 39 years, a residential rental over 27.5. A cost segregation study, performed by an engineering firm, identifies the components that are really 5-, 7-, or 15-year property: carpeting, specialty electrical, appliances, site improvements, parking, landscaping. Reclassifying them front-loads deductions.

Bonus depreciation is the multiplier. OBBBA permanently restored 100 percent bonus depreciation for qualified property with a recovery period of 20 years or less that is acquired and placed in service after January 19, 2025, according to analyses by RSM and other national accounting firms. Everything a cost segregation study moves into the 5-, 7-, or 15-year buckets can typically be deducted entirely in the first year.

Hypothetical example: an investor buys a $4 million apartment property (excluding land) in 2026. A cost segregation study allocates 25 percent, or $1 million, to short-life property. With 100 percent bonus depreciation, the investor deducts roughly $1 million in year one, plus regular depreciation on the remaining $3 million. At a 37 percent federal rate, that is about $370,000 of potential first-year tax savings, if, and only if, the investor can use the losses. Two caveats: accelerated depreciation is recaptured at sale, often at ordinary rates for the short-life property, and a later 1031 exchange of a heavily segregated building requires careful structuring.

Can you actually use the losses? The passive activity rules

Section 469 treats rental real estate as passive by default. Passive losses offset passive income, not wages or portfolio income; unused losses are suspended and carry forward, generally released in full when you sell that property in a taxable sale. A small exception lets active participants deduct up to $25,000 of rental losses against other income, but it phases out between $100,000 and $150,000 of AGI, so it is irrelevant to most high earners.

The exception that matters is real estate professional status (REPS). To qualify in a given year, you must spend more than 750 hours in real property trades or businesses, that must be more than half of all your personal service time, and you must materially participate in the rentals (often via a grouping election). For a married couple, one spouse can qualify on their own, which is why a full-time real estate spouse paired with a high-earning spouse is such a powerful combination: REPS converts the paper losses from cost segregation into deductions against the household's ordinary income. The IRS audits REPS claims with contemporaneous time logs in mind; treat the hours test as a documentation exercise, not an aspiration. A separate, narrower path exists for short-term rentals with average stays of seven days or less, which are not "rental activities" under the regulations and require material participation rather than REPS.

What are the exit strategies?

• Serial exchanges and the step-up. Investors can 1031 from property to property indefinitely. At death, heirs receive a basis step-up under current law, and with a $15 million per person federal estate exemption, the deferred gain often disappears entirely. This is the "swap until you drop" strategy.
• Delaware statutory trusts. A DST interest in institutional property qualifies as 1031 replacement property under IRS Revenue Ruling 2004-86. DSTs solve the 45-day deadline and management burden, but they are illiquid, fee-laden, and dependent on sponsor quality; diligence them like any private placement.
• 721 exchange (UPREIT). Contributing property to a REIT's operating partnership defers gain and converts a building into diversified, income-producing units, but it is a one-way door: the units cannot be 1031-exchanged again, and conversion to REIT shares is taxable.
• Sell and pay. Sometimes recognizing gain at current rates, especially with suspended passive losses available to absorb it, beats another decade of concentrated property risk.

Key numbers

Frequently asked questions

Can I 1031 into a property I already own?No. The exchange requires acquiring new replacement property; transactions with yourself or related parties face special restrictions and holding requirements.

Does a 1031 exchange defer depreciation recapture too?Yes. Both capital gain and recapture are deferred, which is a large part of the strategy's value for long-held, heavily depreciated buildings.

Is 100 percent bonus depreciation scheduled to phase out again?No. OBBBA made 100 percent bonus depreciation permanent for qualified property acquired and placed in service after January 19, 2025, replacing the prior phase-down schedule.

Do I need real estate professional status to benefit from cost segregation?Not always. Losses can offset other passive income, shelter the property's own cash flow, or carry forward to the year of sale. REPS or the short-term rental rules are needed to deduct losses against wages or portfolio income.

Are DSTs safe replacements for direct property?They are legitimate 1031 replacement property, but they carry sponsor risk, fees, illiquidity, and no investor control. They suit investors seeking deferral and passivity, not those seeking maximum return.

What happens to suspended passive losses when I sell?A fully taxable sale of the activity generally releases all suspended losses from that property, which can offset the gain and other income in the year of sale.