I was reviewing Gavin Newsom’s tax returns for content purposes and wanted to share an example of how real estate can be strategically used to offset taxes.
Here’s a Schedule E from his 2019 tax return:
In 2019, he bought a home in California. We can see that his rental received $140,000 of gross rents and had $387,721 of expenses, for a net loss of $247,721.
So, did his California rental lose money? Yes, but only on paper.
If you look closely, $277,271 of expenses came from depreciation, which is a non-cash expense.
This is exactly how rentals can be used strategically to offset taxes.
This $247,721 loss was able to offset $247,721 of other passive income. $247,721 taxed at 37% could mean as much as $90,000 of tax savings for him.
But here are 2 things you most likely will ask:
1. How did he generate so much depreciation?
2. 99% of people don’t have $250,000 of passive income to offset this passive loss. So how can we use a rental loss to offset other income, like W-2 wages?
Let’s tackle both of these.
Depreciation
Every rental building can be depreciated over 27.5 years (residential) or 39 years (commercial).
This is simply a yearly tax deduction you can take due to wear and tear. No cash actually leaves your pocket.
A smart tax planning strategy is to do a “cost segregation” study, where your building is broken down into components (e.g. furniture and fixtures) that can be depreciated over 5 or 7 years.
These components can also be elected to use an accelerated method, like bonus depreciation, which currently allows for a 40% immediate deduction (likely to return to 100% due to the “Big Beautiful Bill” in 2025).
So, let’s look at the tax return again:
Because of the cost segregation, the building was split into the building basis, furniture and fixtures, equipment, and landscape improvements.
These are classified as 5- and 15-year property and received 100% depreciation in Year 1 due to bonus depreciation.
So $55,116 + $36,347 + $133,065 = $224,528 of accelerated depreciation expense.
In addition, he was able to take the regular 27.5-year depreciation on the building structure.
Fun fact: California doesn’t conform to federal bonus depreciation rules, so he likely had to pay state taxes on the rental income.
Offsetting other income
In his case, he was able to use these huge rental losses to offset other passive income from his winery business, making $800,000+ a year.
Passive activity is just a business in which you don’t materially participate, perhaps you just act as a silent partner.
Well, most people wouldn’t typically have those. So how can they use rental losses to offset income?
There are 3 main ways:
- Gross income is less than $150,000
First, if you actively participate in the rental real estate activity (participate in the management decisions), you can deduct a maximum of $25,000 of losses against your active income (like wages or active business income).
However, if your modified adjusted gross income exceeds $100,000 (Section 469(i)(3)(A)), the $25,000 is proportionally phased out and is no longer available once the income reaches $150,000.
- Real estate professional status
Rentals are considered passive by default. However, a rental activity of a taxpayer that qualifies as a “real estate professional” (Section 469(c)(7)) is considered active if the taxpayer materially participates.
In order to qualify as a “real estate professional,” you need to:
- Provide services in real estate trades or businesses for more than 750 hours during the year
- More than ½ of the services that you perform must be in real estate trades or businesses
Because of that second rule, if you are W-2, you will not qualify.
However, if you have a stay-at-home spouse, they could, making your joint return qualified for losses against your W-2. You also need to materially participate in a rental activity (typically 500 hours).
What if you don’t have a spouse?
- Short term rentals
Section 1.469-1T(e)(3)(ii)(A) states that if the average stay of a customer is less than 7 days, such activity is not considered a rental activity.
However, to take the losses, you still have to materially participate (typically 500 hours, but there are other options, like at least 100 hours and more than anyone else).
So, you have another option to rent on Airbnb/VRBO short term rentals, but those come with some risk (like cities banning short-term rentals), and you have to be involved due to the hours requirement.
Quick example
Say you buy a rental worth $500,000.
Generally, this is heavily dependent on location, but say 80% of this cost is allocated to the building and 20% to the land.
So, from $420,000, we can use a cost segregation study to get around 20–30% of that amount to be immediately expensed.
Using 40% bonus depreciation, we can get roughly $40,000 of depreciation in Year 1.
If the “Big Beautiful Bill” passes, it will be $100,000 of depreciation in Year 1.
If you have REPS or a short-term rental, you can take these losses against your income.
If you are in a 37% marginal tax break, that’s tens of thousands in savings.
Note: the math still works even if you buy it with a mortgage.
Summary
Importantly, tax savings don’t matter if the investment is a terrible one causing you to lose money.
Don’t try to save 37 cents on taxes if you waste a dollar.
In other words, make sure the ROI is better than just keeping the money in your savings account.
Analyze rental growth, expected expenses, tax benefits, and equity paydown to see if it makes sense, or whether you should just invest in ETFs instead.
Hope you enjoyed this one.
See you next Saturday.