Costly Tax Mistakes Rental Property Owners Make & How to Avoid Them

Owning rental property can be a smart way for small and medium business owners to build long-term wealth, diversify income, and gain valuable tax advantages. But real estate also brings a maze of complex tax rules — and even seasoned business owners can stumble.

At KFM, we often see first-time landlords unintentionally trigger audits or miss out on huge deductions simply because they didn’t fully understand the rules.

To protect your profits and stay compliant, here are six common tax mistakes new rental property owners make — and what to do instead.

Failing to Properly Depreciate the Property

Why it matters:
Depreciation is one of the largest tax benefits of owning real estate. The IRS allows you to recover the cost of the building (not the land) over 27.5 years for residential property. This deduction is non-cash — meaning you don’t have to spend anything to claim it.

Common mistake:
New landlords often forget to start depreciation when the property is placed in service or incorrectly allocate the purchase price between land and building. This can result in lost deductions now and recapture taxes later when you sell.

Best practices:

• Determine the building’s cost basis (purchase price minus land value from your property tax assessment).

• Begin depreciation in the month the property is first available for rent.

• Include eligible capital improvements (roof, HVAC, additions) in your depreciation schedule.

• Track state conformity rules — most states follow federal depreciation, but a few (like Massachusetts) require adjustments.

Misunderstanding Passive Activity Loss Rules

Why it matters:
By default, rental real estate is considered a passive activity. Losses from passive activities can only offset passive income — not your active business income or salary.

Common mistake:
New owners often assume they can deduct rental losses against other income, only to discover those losses are suspended and carried forward until they have passive income or sell the property.

What you should know:

• You may qualify for the $25,000 special allowance if you actively participate and your modified adjusted gross income (MAGI) is under $100,000. (This phases out completely at $150,000.)

• Suspended passive losses are not gone forever — they can be used when you generate passive income or dispose of the property in a taxable sale.

Not Understanding the “Real Estate Professional” Rules

Why it matters:
If you or your spouse qualify as a real estate professional, your rental activity may be treated as non-passive — allowing you to deduct losses against all types of income.

Requirements:

• More than 750 hours per year of real estate activities

• More than 50% of your total working time spent in real property trades or businesses

• Material participation in your rental activities

This status can be a powerful tax planning tool for business owners who are heavily involved in real estate, but the rules are strict and heavily scrutinized by the IRS. You need detailed time logs and documentation to defend your position.

Not Reporting All Rental Income

Why it matters:
The IRS receives information on payments from platforms like Airbnb, VRBO, and property managers through Form 1099-K and Form 1099-MISC. Failing to report even small amounts can trigger IRS notices.

Common pitfalls:

• Forgetting to report security deposits kept due to tenant damages (these become income if not returned)

• Misreporting personal use days in vacation rentals, which can disallow deductions

• Skipping small cash or Venmo payments from tenants

Always reconcile your reported income with 1099s you receive — the IRS will match them.

Inadequate Record Keeping

Why it matters:
If you can’t prove your income, expenses, or time spent on the property, you could lose deductions or fail to qualify for valuable tax breaks.

Best practices:

• Maintain a separate bank account for rental activity

• Track all income and expenses with software or spreadsheets

• Save receipts, invoices, mileage logs, and lease agreements

• Keep time logs if you aim to qualify as a real estate professional

Well-organized records are also essential if you plan to refinance, sell, or bring in investors later.

Not Using Tax Strategies to Minimize Liability

Big picture:
Many landlords treat their rental activity as something to “figure out at tax time.” This reactive approach often means missing out on proactive planning opportunities.

Strategies to consider:

• Cost segregation studies to accelerate depreciation on certain building components

• Grouping elections to combine multiple rental activities and meet material participation tests

• Entity structuring (LLCs or partnerships) for liability protection and better tax flexibility

• State tax planning if your property is located in a different state than your business or residence

A proactive strategy can dramatically improve your cash flow, especially in the first few years of ownership.

The Bottom Line

Real estate can be a powerful tool for building wealth — but it’s also heavily regulated and full of traps for the unwary. Failing to understand depreciation, passive activity rules, and record-keeping requirements can cost thousands in lost deductions and penalties.

At KFM, we help small and medium business owners approach rental property like a business — with solid systems, smart strategies, and year-round tax planning to maximize profits and minimize surprises.

📩 Want to get your rental property set up the right way? Contact KFM today to schedule a consultation and start building a strong financial foundation.