Real Estate Tax Strategy California

Real Estate Tax Strategy Overview

Real estate is one of the most tax-advantaged asset classes available to California investors. The combination of depreciation deductions, 1031 exchange deferral, cost segregation, and the step-up in basis at death can allow real estate investors to build significant wealth while deferring or eliminating taxes. KDA specializes in real estate tax planning for California investors, from single rental properties to large commercial portfolios.

1031 Exchange

A 1031 exchange (like-kind exchange) allows you to defer capital gains tax when you sell investment real estate by reinvesting the proceeds in a replacement property. The gain is deferred — not eliminated — until you eventually sell the replacement property without doing another exchange. Key rules: (1) Both the relinquished and replacement properties must be held for investment or business use. (2) You must identify the replacement property within 45 days of the sale. (3) You must close on the replacement property within 180 days of the sale. (4) The replacement property must be of equal or greater value than the relinquished property. KDA coordinates 1031 exchanges with qualified intermediaries and ensures all deadlines are met.

Cost Segregation

Cost segregation is an engineering-based tax strategy that accelerates depreciation deductions on commercial and residential rental properties. Instead of depreciating the entire building over 27.5 years (residential) or 39 years (commercial), a cost segregation study identifies components that can be depreciated over 5, 7, or 15 years — dramatically accelerating the depreciation deductions. With 100% bonus depreciation restored by the OBBBA, components with a 5- or 7-year life can be fully expensed in the year placed in service. A cost segregation study on a $2 million commercial building can generate $300,000–$500,000 in additional first-year depreciation deductions.

Depreciation & Bonus Depreciation

Real estate investors can deduct depreciation on rental properties — the IRS allows you to recover the cost of the building (not the land) over 27.5 years (residential) or 39 years (commercial). Depreciation is a non-cash deduction that reduces taxable income without a cash outlay. The OBBBA permanently restored 100% bonus depreciation for qualifying property placed in service after January 19, 2025. This allows investors to immediately expense the cost of personal property components identified in a cost segregation study. Note: California does not conform to federal bonus depreciation — California depreciation deductions are calculated separately.

Passive Activity Rules

Rental real estate is generally treated as a passive activity — losses can only offset passive income, not wages or active business income. However, there are two important exceptions: (1) $25,000 allowance — if you actively participate in rental activities and your AGI is under $100,000, you can deduct up to $25,000 of rental losses against ordinary income. The allowance phases out between $100,000 and $150,000 AGI. (2) Real estate professional status — if you spend more than 750 hours per year in real estate activities and more than half your working time is in real estate, your rental losses are not passive and can offset all income. KDA helps real estate investors qualify for and document real estate professional status.

California Real Estate Tax Issues

California has several state-specific real estate tax issues: (1) Proposition 13 — limits property tax increases to 2% per year; reassessment is triggered by a change in ownership. (2) Proposition 19 — significantly changed the parent-child transfer exclusion for inherited property. (3) California does not conform to federal bonus depreciation — California requires separate depreciation calculations. (4) California does not have a 1031 exchange clawback rule — unlike some states, California does not require you to pay California tax when you sell a replacement property located outside California. (5) California capital gains tax — California taxes capital gains as ordinary income at rates up to 13.3%.