Tax Services for Real Estate Investors

A cost segregation study is an engineering-based analysis that reclassifies components of a building from the default 27.5-year residential or 39-year commercial depreciation schedule into shorter-lived asset categories — typically 5-year, 7-year, or 15-year property. The result is dramatically accelerated depreciation deductions in the early years of ownership, which directly reduces your taxable income. For Los Angeles real estate investors, a cost segregation study is almost always worth it on properties valued at $500,000 or more, and the return on investment is typically 10-to-1 or better when you factor in the time value of the accelerated deductions.

Here’s a concrete example. You buy a $2 million apartment building in Silver Lake. Under normal depreciation, the building (excluding land, which isn’t depreciable) might have a depreciable basis of $1.5 million. Over 27.5 years, that gives you about $54,545 per year in depreciation. Now you commission a cost segregation study. The engineers inspect the property and identify that $225,000 of the depreciable basis qualifies as 5-year property (appliances, carpeting, certain plumbing fixtures, decorative lighting), $75,000 qualifies as 7-year property (movable fixtures, specialty electrical), and $150,000 qualifies as 15-year property (land improvements like parking lots, sidewalks, landscaping, fencing). The remaining $1,050,000 stays on the 27.5-year schedule.

With bonus depreciation still available (100% for assets placed in service before January 1, 2023, stepping down 20% per year thereafter — so 40% for 2025, 20% for 2026, and 0% for 2027 unless Congress extends it), you could potentially deduct a substantial portion of that reclassified property in Year 1. Even without bonus depreciation, the accelerated schedules front-load your deductions: instead of $54,545 per year straight-line, you might get $150,000+ in depreciation in the first year, tapering down over time. At California’s combined federal and state marginal rates (which can exceed 50% for high earners), that extra $95,000+ in first-year depreciation could save you $47,500 or more in taxes in Year 1 alone.

The study itself typically costs between $5,000 and $15,000 for a residential property and $10,000 to $25,000 for a commercial property, depending on the size and complexity. For a $2 million property generating $47,500+ in first-year tax savings, the ROI is obvious. Even on smaller properties — say a $750,000 duplex in Echo Park — a cost seg study might cost $5,000 and generate $15,000 to $20,000 in accelerated tax benefits. The breakeven is almost always in your favor.

There are some situations where a cost segregation study might not make sense. If you’re planning to sell the property within 2-3 years, the depreciation recapture on sale (taxed at 25% under Section 1250 for the amount of depreciation taken) could offset much of the benefit. If your income is below the thresholds where the passive activity loss rules limit your ability to use depreciation deductions (more on that below), the accelerated depreciation might just create suspended losses rather than current-year tax savings. And if you’re already in a low tax bracket for other reasons, the benefit of accelerating deductions into the current year is smaller.

The passive activity loss rules under IRC Section 469 are the biggest practical limitation. Rental real estate is generally treated as a passive activity, which means depreciation losses from rental properties can only offset other passive income (like rental income from other properties) — they can’t offset your W-2 income or active business income unless you qualify as a Real Estate Professional (REPS) under Section 469(c)(7). If you do qualify as a REPS (see the FAQ below), all your rental losses — including accelerated depreciation from a cost seg study — become nonpassive and can offset any type of income. This is why cost segregation studies and REPS status are such a powerful combination for LA real estate investors: the cost seg creates massive paper losses, and REPS status lets you use those losses against your other income.

If you don’t qualify as a REPS, there’s still the $25,000 special allowance under Section 469(i) for active participants in rental activities with modified AGI under $100,000 (phasing out completely at $150,000 MAGI). But $25,000 is a relatively small window, and many LA real estate investors blow past the income threshold easily.

One California-specific consideration: California conforms to federal depreciation rules, including bonus depreciation for assets placed in service in certain years. However, California has historically decoupled from federal bonus depreciation for some periods, requiring a California depreciation adjustment on your state return. Check the current conformity status with your CPA. Even if California doesn’t allow bonus depreciation, the accelerated regular depreciation from the reclassified asset lives (5, 7, 15 years vs. 27.5 or 39) still provides a significant California benefit.

Lookback studies are also worth mentioning. If you’ve owned a property for several years and never did a cost segregation study, you can do one now and catch up on the missed accelerated depreciation by filing Form 3115 (Application for Change in Accounting Method). This lets you take the cumulative “catch-up”. Depreciation — the difference between what you actually deducted and what you could have deducted with the reclassified assets — as a one-time adjustment in the current year. You don’t need to amend prior returns. For an investor who bought a $3 million property five years ago and has been depreciating everything on 27.5 years, a lookback cost seg study could generate a six-figure catch-up deduction in a single year. For more on how depreciation flows through your tax return, check our Form 1040 guide.

California tracks 1031 exchange gains with a level of precision and persistence that surprises many Los Angeles real estate investors, especially those who complete an exchange out of California into property in another state. The state uses Form FTB 3840, which you’re required to file every single year after completing a 1031 exchange involving California property — and you keep filing it until you eventually sell the replacement property in a fully taxable sale. California wants to make sure it eventually collects tax on the gain you deferred, and Form 3840 is how they keep tabs on you.

Here’s the scenario that triggers the most scrutiny. You own a rental property in Los Angeles — let’s say a fourplex in Koreatown that you bought for $800,000 and is now worth $2.2 million. You do a 1031 exchange into a larger apartment building in Phoenix, Arizona. At the federal level, this exchange defers the entire $1.4 million gain (minus any depreciation recapture and adjusted basis calculations). You don’t pay federal tax yet. But California takes the position that the gain is California-source income because the relinquished property was in California, and the state intends to tax that gain eventually — either when you sell the replacement property in a taxable sale or when you die (if the step-up in basis doesn’t eliminate the deferred gain for state purposes).

Form FTB 3840 requires you to report the details of the original exchange, the deferred gain, and the current status of the replacement property every year. If you sell the replacement property in Arizona in a taxable transaction, California will assess tax on the deferred gain from the original California property. The California tax rate on that gain could be up to 13.3% for high-income individuals. On a $1.4 million deferred gain, that’s up to $186,200 in California tax — which is why some investors think twice about exchanging out of California.

If you do a subsequent 1031 exchange — selling the Arizona property and exchanging into yet another property in, say, Texas — California still tracks the original deferred gain. The gain doesn’t disappear through successive exchanges. It just keeps rolling forward. You continue filing Form 3840 every year, and the deferred gain from the original California property is still in California’s records. Only a taxable disposition ends the tracking requirement (and triggers the tax).

What if you forget to file Form 3840? California imposes a penalty of the greater of $500 or 10% of the deferred gain for failure to file. On a $1.4 million deferred gain, the penalty would be $140,000 per year of non-filing. In practice, the FTB (Franchise Tax Board) typically assesses penalties at the $500 level for first-time non-filers, but they have the authority to go higher, and repeated non-filing raises the stakes. The FTB has gotten increasingly sophisticated about identifying taxpayers who completed exchanges and moved out of state — they share data with other state tax agencies and cross-reference federal filings.

Multi-property exchanges add complexity. If you exchange one California property into two replacement properties in different states, you need to allocate the deferred gain across the replacement properties and track each one separately. If you later sell one replacement property and keep the other, you only recognize the portion of the deferred gain allocated to the sold property (assuming the allocation was done properly at the time of the exchange). The math gets complicated quickly, and mistakes in the allocation can result in double taxation or missed tax.

California’s estate tax situation adds another dimension. At the federal level, when you die, your heirs receive a stepped-up basis to fair market value under IRC Section 1014, which eliminates the built-in gain (including the deferred 1031 exchange gain) for federal purposes. California doesn’t have a state estate tax, and historically the step-up has applied for state income tax purposes too. So one strategy has been to hold the replacement property until death, let the heirs get the stepped-up basis, and avoid the California tax entirely. However, this is a legislative risk — California could change its rules, and some politicians have proposed eliminating or limiting the step-up at the state level. Don’t plan your entire exit strategy around a rule that might change.

For LA real estate investors considering a 1031 exchange, the California tracking rules shouldn’t scare you away from exchanging, but they should factor into your decision-making. Exchanging from California to California keeps things simpler from a state tax perspective (the gain stays in California either way). Exchanging out of California defers the federal tax but creates a perpetual state filing obligation and an eventual California tax bill. Running the numbers with your CPA before you exchange — including the present value of the tax deferral vs. the eventual California tax plus the annual compliance cost of filing Form 3840 — is the right move. For more on how capital gains and property sales flow through your return, see our Form 1040 guide.

Also worth noting: the qualified intermediary you use for the 1031 exchange should be familiar with California’s reporting requirements and should provide you with the information needed to complete Form 3840. If your QI doesn’t mention the 3840 filing requirement, that’s a red flag about their experience — and you might want a more experienced intermediary. The exchange itself has strict timelines (45 days to identify replacement property, 180 days to close), and the California overlay adds another compliance layer that you don’t want to miss.

Technically yes, but practically it’s extremely difficult — and the IRS knows it. Real Estate Professional Status (REPS) under IRC Section 469(c)(7) requires you to meet two tests in the same tax year. First, you must spend more than 750 hours during the year in real property trades or businesses in which you materially participate. Second, more than half of your total personal services during the year must be in real property trades or businesses. Both tests must be met. And if you have a full-time W-2 job that isn’t in a real property trade, that second test — the more-than-50% test — becomes a mathematical problem.

Let’s do the math. A standard full-time job involves approximately 2,080 hours per year (40 hours x 52 weeks). To have more than 50% of your personal services in real estate, you’d need to spend more than 2,080 hours in real estate activities — meaning you’d need to log at least 2,081 hours managing your properties on top of your 2,080-hour day job. That’s over 4,161 total work hours in a year, which works out to about 80 hours per week, every week, with no vacations. It’s not literally impossible, but it’s unrealistic for most people, and the IRS will be skeptical of any such claim.

There’s a nuance worth exploring, though. The 50% test counts “personal services performed in all trades or businesses” — not just your W-2 job. If your W-2 job is part-time (say, 25 hours per week or 1,300 hours per year), the math gets much more feasible. You’d need more than 1,300 hours in real estate activities, plus you’d still need to meet the 750-hour minimum (which is automatically met if you hit 1,300+). Similarly, if your W-2 job is in a real property trade or business — you’re an architect, a contractor, a real estate broker, a property manager, or you work for a development company — those W-2 hours count toward both the 750-hour test and the 50% test. In that case, meeting REPS with a full-time job is straightforward because your job itself is the qualifying activity.

For LA real estate investors with non-real-estate day jobs, the most common path to REPS is through a spouse. If you’re married filing jointly and one spouse qualifies as a Real Estate Professional, the couple gets the benefit on their joint return. So if your spouse manages the rental properties full-time (or at least more than 750 hours and more than half their working time), the passive activity loss limitations are lifted for rental activities in which the qualifying spouse materially participates. This is a huge deal in Los Angeles where property values are high — a single rental property generating $50,000+ per year in depreciation can wipe out a significant chunk of taxable income if the losses are reclassified as nonpassive through REPS.

Material participation is the other requirement, and it’s separate from the REPS qualification. Even after qualifying as a Real Estate Professional, you (or your qualifying spouse) must materially participate in each rental activity for that activity’s losses to be treated as nonpassive. Material participation generally means spending 500+ hours per year on the activity, though there are other tests (being the only person who participates, participating more than any other individual, etc.). You can also elect to aggregate all your rental activities into a single activity under Section 469(c)(7)(A), which means the 500-hour test is applied to all your rentals combined rather than separately. For an investor with multiple properties, the aggregation election is almost always the right move because it’s much easier to meet 500 hours across all properties than 500 hours per property.

The IRS audits REPS claims aggressively, and the courts have established clear standards for what counts. You need a contemporaneous time log — ideally kept in real time (daily or weekly entries), not reconstructed at year-end. The log should describe the specific activities performed: tenant screening, lease negotiations, property inspections, coordinating repairs, reviewing financials, meeting with property managers, overseeing renovations, researching potential acquisitions. Travel time to and from properties counts. Time spent on your own property management tasks counts. Time on the phone with tenants, contractors, or your property manager counts. What doesn’t count: time spent as an investor evaluating deals you don’t end up doing, time reading general real estate news, or time managing personal residences.

If you use a property management company (which many LA investors do given the complexity of LA’s rent control ordinances and tenant protection laws), you can still qualify for REPS — but the management company’s hours don’t count toward your 750. You need to demonstrate that you’re making the management decisions: approving tenants, setting rents, approving expenditures, directing the property manager. Courts have generally held that using a property manager doesn’t disqualify you from REPS, but it does reduce the hours you can personally claim, so you need to be actively involved.

One more consideration for LA investors: California conforms to the federal passive activity loss rules, so qualifying for REPS at the federal level also benefits you at the state level. Given California’s high tax rates (up to 13.3%), the state tax savings from REPS can actually exceed the federal savings. A $100,000 passive loss that becomes nonpassive through REPS saves up to $13,300 in California tax alone, on top of up to $37,000 in federal tax. That’s a combined benefit of up to $50,300 from a single year’s rental losses. For more on entity structuring and how rental income flows through different business types, see our LLC tax guide.

Bottom line: if you have a full-time non-real-estate job, your best path to REPS is through a qualifying spouse. If you’re single or your spouse also has a full-time non-real-estate job, REPS is extremely unlikely unless you reduce your day job to part-time. Don’t claim REPS without genuinely meeting the requirements — the penalties for underpaying tax due to a disallowed REPS claim include accuracy-related penalties of 20% of the underpayment under IRC Section 6662.

Yes, Proposition 19 significantly changed the rules for inherited rental property in California, and for Los Angeles real estate investors who were planning to pass properties to their children, it was a major blow. Before Prop 19 took effect on February 16, 2021, parents could transfer real property to their children (and grandchildren, under certain conditions) without triggering a reassessment of the property’s taxable value for property tax purposes. This was under the old Proposition 58 (parent-child) and Proposition 193 (grandparent-grandchild) exclusions. Children could inherit a rental property with the parent’s low Prop 13 assessed value — often a fraction of the property’s current market value — and continue paying property taxes based on that low assessment indefinitely.

Under the old rules, there was no limit on the value of a primary residence that could be transferred without reassessment, and up to $1 million in assessed value of other property (rental property, commercial property, vacant land) could be transferred without reassessment per parent per child. So a parent with a rental property in Venice Beach that was assessed at $200,000 (purchased in 1985) but now worth $3.5 million could transfer it to their child, and the child would continue paying property taxes based on the $200,000 assessment — roughly $2,500 per year instead of the $43,750 per year that would result from reassessment to current market value. Over 20 years of ownership, that’s a difference of over $825,000 in property taxes.

Proposition 19 gutted this benefit for rental and investment properties. Under the new rules (effective February 16, 2021), the parent-child exclusion from reassessment is limited to a family home (the primary residence of either the parent or the child) and a family farm. Rental properties, commercial properties, vacation homes, and vacant land no longer qualify for the exclusion. Period. If a parent transfers a rental property to a child after February 16, 2021 — whether by gift during life or by inheritance at death — the property gets reassessed to current market value, and the child pays property taxes based on that higher value from now on.

Even for family homes, Prop 19 added restrictions that didn’t exist before. The child must use the inherited home as their own primary residence and must file a homeowner’s exemption within one year of the transfer. If the home’s market value exceeds the parent’s assessed value by more than $1 million, the excess gets added to the tax base. So if a parent’s Venice Beach house was assessed at $200,000 and the market value at transfer is $3.5 million, the child’s new assessed value would be $200,000 + ($3,500,000 – $200,000 – $1,000,000) = $2,500,000. That’s still lower than the full $3.5 million, but much higher than the $200,000 the child would have gotten under the old rules. And if the child doesn’t move in and use it as their primary residence? Full reassessment to $3.5 million.

For Los Angeles real estate investors with multiple properties, Prop 19 requires a fundamental rethinking of estate and succession planning. Before Prop 19, a common strategy was to hold rental properties in the family for generations, passing them from parent to child while maintaining the low Prop 13 assessed value. A family that owned five rental properties in LA with a combined assessed value of $1 million (but a combined market value of $15 million) was paying about $12,500 per year in total property taxes. Under the old rules, the children could inherit all five properties and continue paying that $12,500 per year. Under Prop 19, those properties would be reassessed to $15 million upon transfer, and the annual property tax bill would jump to approximately $187,500. That $175,000 annual increase makes some inherited rental portfolios economically unviable — the property taxes eat into the rental income to the point where the properties may need to be sold.

There are some planning strategies that LA real estate families are using to work around Prop 19, though each has limitations. Transferring properties into an LLC or other entity before Prop 19 took effect (if done before February 16, 2021) may have preserved the old exclusion, though the FTB and county assessors have been scrutinizing these transfers. Using a trust structure doesn’t change the outcome — Prop 19 applies to transfers regardless of whether they occur directly or through a trust. Transferring properties as gifts during the parent’s lifetime (rather than waiting for inheritance) doesn’t help either — Prop 19 applies to both lifetime transfers and transfers at death.

One strategy that still works is selling the property rather than gifting or bequeathing it. If the parent sells the property to the child at fair market value, the child’s property tax basis is the purchase price — which is what it would be under Prop 19 anyway. But the sale triggers capital gains tax for the parent, whereas inheritance typically gets a stepped-up basis under IRC Section 1014, which wipes out the capital gains tax. So the choice is between paying capital gains tax on sale (federal + California rates potentially totaling 33% or more on the gain) or paying higher property taxes for decades after inheriting the property. The math depends on the size of the gain, the expected holding period, and the rental income the property generates.

Another approach is to use a charitable remainder trust (CRT). The parent transfers the property to a CRT, which sells the property tax-free (because the CRT is a tax-exempt entity). The CRT invests the proceeds and pays the parent (and potentially the spouse) an income stream for life. At the end of the trust term, the remaining assets go to a charity. This eliminates both the capital gains tax and the property tax problem, but it also means the children don’t get the property. It’s a solution for investors whose priority is income and tax efficiency rather than passing specific properties to heirs.

Prop 19 did create one benefit: it expanded the ability of homeowners over 55, the severely disabled, or wildfire/disaster victims to transfer their property tax basis to a new home anywhere in California, up to three times. This is useful for downsizing retirees but doesn’t help with rental property succession. For a complete picture of how property ownership and capital gains interact with your tax situation, see our Form 1040 guide and our LLC tax return page for entity structuring considerations.

The “mansion tax” — formally Measure ULA (United to House LA) — took effect on April 1, 2023 and imposes a transfer tax on sales of real property in the City of Los Angeles that exceed certain price thresholds. For sales between $5 million and $10 million, the tax rate is 4% of the entire sale price (not just the amount above $5 million). For sales over $10 million, the rate jumps to 5.5%. This is in addition to the existing city and county documentary transfer taxes, which combined run about 0.56% of the sale price. So a $12 million property sale in LA now triggers a total transfer tax of approximately $726,720 ($660,000 from Measure ULA at 5.5% plus $67,200 from existing transfer taxes at 0.56%), compared to $67,200 before Measure ULA. That’s a more-than-ten-fold increase for high-value properties.

For LA real estate investors, the mansion tax changes the math on acquisitions and hold periods in several important ways. First, the tax applies to the seller — it’s a cost of selling, not buying. So if you own a commercial building or a portfolio of apartment units that together sell for over $5 million, you’re the one paying the tax. This means the effective gain from selling a high-value property is substantially reduced, and investors need to factor the mansion tax into their exit strategy from the moment they acquire a property.

Let’s walk through a real example. You bought a 20-unit apartment building in Mar Vista in 2015 for $4.2 million. You’ve made $800,000 in capital improvements over the years. Your adjusted basis is $5 million (simplified). The building is now worth $8 million. If you sell for $8 million, your Measure ULA tax is 4% x $8,000,000 = $320,000. Your existing transfer taxes are about $44,800. Your federal capital gains tax on the $3 million gain (after depreciation recapture adjustments) might be around $720,000 (at 20% + 3.8% NIIT). Your California capital gains tax is about $399,000 (at 13.3%). Real estate commissions at 5% are $400,000. After all costs, your net proceeds are roughly $6,116,200 on a property you bought for $4.2 million. The mansion tax alone represents $320,000 of friction — money that would have been in your pocket before April 2023.

The mansion tax has accelerated interest in 1031 exchanges among LA investors. Because the tax applies to “sales”. Of real property, and a 1031 exchange is technically a sale (followed by a purchase of replacement property), the mansion tax applies to the relinquished property leg of the exchange. There’s been legal debate about whether certain exchange structures could mitigate the tax, but the City’s position is clear: the transfer tax applies when the property changes hands, regardless of whether the transaction is part of a 1031 exchange. That said, a 1031 exchange still defers the federal and state capital gains taxes, which are typically larger than the mansion tax. So the exchange still makes sense in most cases — you just can’t escape the ULA tax.

Some investors have tried to structure transactions to avoid triggering the tax. Common approaches include splitting a property into multiple units or parcels and selling them separately below the $5 million threshold, structuring the sale as a lease or ground lease rather than a fee simple transfer, or selling the entity that owns the property (LLC membership interests) rather than the property itself. The City of Los Angeles anticipated some of these strategies and included anti-avoidance provisions in the measure. Transfers of controlling interests in entities that own LA real property are treated as transfers of the property itself. Splitting a sale into multiple transactions to stay below the threshold is also addressed. The City’s Office of Finance has enforcement authority and has issued guidance on what constitutes an avoidable transfer.

Entity transfers deserve special attention. If you own an LLC that holds a $7 million apartment building, and you sell 100% of the LLC membership interests to a buyer, Measure ULA treats that as a transfer of the real property and imposes the 4% tax. But if you sell a 49% interest? The current threshold is based on “controlling interest” — for an LLC, that’s more than 50% of the ownership interests transferred to one person or related group within a 12-month period. So selling a minority interest might not trigger the tax, but selling a majority interest would. This creates planning opportunities for investors who can structure partial interest sales, joint ventures, or phased dispositions — but the rules are complex and the City is watching for abuse.

For investors considering new acquisitions in LA, the mansion tax changes the underwriting calculus. When you model your exit in 5, 7, or 10 years, you now need to include 4% or 5.5% of the projected sale price as an additional cost. For a property you expect to sell for $6 million in 7 years, that’s $240,000 in mansion tax that reduces your IRR. Some investors are shifting their acquisition focus to properties outside the City of Los Angeles but within Los Angeles County — cities like Burbank, Pasadena, Glendale, Santa Monica, and Long Beach are not subject to Measure ULA (they may have their own transfer taxes, but at much lower rates). The economic impact has been measurable: high-end property transaction volume within the City of LA dropped significantly after the tax took effect.

Measure ULA also affects development projects. If a developer builds a new project and sells units or the entire project for over $5 million, the tax applies. For condominium developments, each unit sale is a separate transfer — so individual unit sales under $5 million aren’t subject to ULA, even if the total project value exceeds $5 million. But for apartment or commercial developments sold as a single property, the full sale price triggers the tax. This has caused some developers to rethink project sizing and phasing to manage the tax impact.

There’s ongoing legal uncertainty around Measure ULA. Legal challenges have been filed arguing that the measure conflicts with state law, and the outcome of those challenges could potentially invalidate or modify the tax. As of now, the tax is being collected and enforced, so investors should plan around it regardless of the legal challenges. If it’s eventually struck down, that’s a bonus — but don’t count on it. For planning strategies around capital gains, entity structuring, and 1031 exchanges in the context of the mansion tax, our team at The Reed Corporation works with LA real estate investors daily on these exact issues.