How LA Landlords Collect Rent All Year and Legally Show the IRS a Loss
By The Tax Shack | July 2026 | Los Angeles, CA
If you own a rental property in Los Angeles, there's a section of the tax code working in your favor right now, and most landlords have never had it explained to them clearly.
You can collect rent every month, pocket real cash, and still show the IRS a loss on paper. It's not a loophole. It's not a gray area. It's written directly into the tax code, and it's called depreciation.
Here's how it actually works.
The Basic Idea: The Paper Loss
The IRS operates on a simple assumption: buildings wear out over time. So it lets you deduct that wear as a yearly expense, even though no money ever actually leaves your pocket.
For residential rental properties, the IRS spreads that deduction over 27.5 years. California conforms to this same rule. (IRS Publication 527; California Franchise Tax Board)
Here's what that means in practice.
A Real LA Example
Let's use realistic LA numbers. Say you own a duplex in the Valley worth $900,000. The land is worth $200,000, and land doesn't depreciate. The building value is $700,000.
$700,000 ÷ 27.5 years = $25,454 per year in depreciation every year, automatically, with no cash out of pocket.
Now let's run the numbers:
Annual rent collected: $48,000 ($4,000/month combined from both units)
Mortgage interest, property taxes, insurance, repairs, management fees: $35,000
Real cash profit in your pocket: $13,000
Minus depreciation deduction: $25,454
What the IRS sees on Schedule E: a $12,454 loss
Your bank account is up $13,000. Your tax return shows a loss. Tax owed on that rental income: $0. Depending on your income, that paper loss may also offset other income.
Landlords call this a paper loss. It is not fraud. It is how the code is written.
The Passive Loss Rules: Who Can Use This
There's an important limitation worth knowing.
Under IRS rules, rental losses are generally considered "passive", meaning they can only offset other passive income, not your regular W-2 or business income. (IRS Publication 527)
However, there are two key exceptions:
The $25,000 allowance. If your adjusted gross income is under $100,000, you can deduct up to $25,000 in rental losses against your ordinary income. This phases out between $100,000 and $150,000 AGI.
Real estate professional status. If you materially participate in real estate activities for more than 750 hours per year and it's your primary profession, passive loss limitations don't apply. You can use rental losses to offset any income. This is a significant tax status that requires proper documentation and is worth a dedicated conversation with your tax preparer.
The California Wrinkle: Two Depreciation Schedules
Here's where it gets specific to California landlords and where many people get tripped up.
California conforms to the standard 27.5-year straight-line depreciation on the building itself. But when it comes to accelerated depreciation on improvements and personal property in things like appliances, flooring, HVAC components… California and federal rules diverge.
Under the OBBBA, 100% bonus depreciation was restored federally for qualifying property placed in service after January 19, 2025. So if you spent $50,000 renovating a rental unit in 2026, you can deduct the full $50,000 on your federal return in year one.
California does not conform to federal bonus depreciation. The state disallows it entirely and limits Section 179 expensing to $25,000, compared to the federal limit. (California Franchise Tax Board)
The result: that same $50,000 improvement gets a $50,000 federal deduction in year one, and a much smaller deduction on your California return, spread over the asset's useful life instead.
Over the property's life, the deferred state deductions catch up. California has not eliminated the deduction, just delayed it. But in the short term, your federal and California returns will show different numbers, and both schedules need to be tracked correctly.
The One Trap: Depreciation Recapture
Here's the part most landlords don't hear until it's too late.
All those years of depreciation deductions? The IRS keeps track of them. The day you sell the property, it claws them back… taxing all previously claimed depreciation at up to 25%. This is called depreciation recapture, and it can mean years of accumulated paper losses coming due in one single bill on the year you sell.
On our example duplex, after 15 years of depreciation you'd have claimed roughly $381,000 in deductions. Selling without a plan could mean a recapture bill of nearly $95,000 on top of any capital gains tax.
Experienced landlords almost never just sell. They use two exits instead.
Exit 1: The 1031 Exchange
A 1031 exchange lets you sell one investment property and roll the proceeds into another. This is deferring the entire tax bill including depreciation recapture. (IRS Section 1031)
You swap the duplex for a larger building, and the tax obligation carries forward rather than coming due. You keep compounding your real estate portfolio without handing a chunk to the IRS each time you upgrade.
There are strict rules: you must identify a replacement property within 45 days and close within 180 days. A qualified intermediary must hold the funds in between. Done right, it's one of the most powerful wealth-building tools in the tax code.
Exit 2: Step-Up in Basis ("Swap Till You Drop")
The second exit is to never sell at all.
Under IRC Section 1014, when heirs inherit a property, their cost basis is stepped up to the fair market value at the time of inheritance. All that accumulated depreciation, and the recapture tax that goes with it, is essentially erased.
Real estate investors call the combination of these two strategies "swap till you drop": keep doing 1031 exchanges to defer taxes while building the portfolio, then pass the properties to heirs at stepped-up basis, wiping out the deferred liability entirely.
Whether this strategy is right for your exact situation depends on your goals, your estate plan, and your income. It's a conversation worth having before you ever list a property for sale.
What This Means for LA Landlords
LA real estate values mean the depreciation math works in your favor. We’re talking larger building with higher assessed values and bigger annual deductions. But the complexity also goes up: California's non-conformity on bonus depreciation means your federal and state returns will look different, and depreciation recapture on high-value LA properties can be substantial without a plan.
At TheTax Shack, our CTEC-certified preparers work with LA property owners on exactly these questions, from correctly filing your Schedule E to planning around depreciation recapture before you sell. Stop by our Encino office or give us a call.
Quick-Answer FAQ
What is rental property depreciation? A yearly tax deduction for the wear on your rental building, spread over 27.5 years for residential property. The deduction requires no cash out of pocket. It's a paper expense that reduces your taxable rental income. (IRS Publication 527)
What is a paper loss on a rental property? When your depreciation deduction exceeds your net rental profit, your property shows a loss on your tax return even though you collected positive cash flow. This is legal, common, and written directly into the tax code.
Does California follow the same depreciation rules as the federal government? For the standard 27.5-year building depreciation — yes. For bonus depreciation on improvements and personal property — no. California disallows federal bonus depreciation entirely and limits Section 179 to $25,000, requiring landlords to track separate federal and state depreciation schedules. (California Franchise Tax Board)
What is depreciation recapture? When you sell a rental property, the IRS taxes all previously claimed depreciation at up to 25%. Years of paper losses can come due in one bill. A 1031 exchange or step-up in basis strategy can defer or eliminate this liability. (IRS Publication 544)
What is a 1031 exchange? A tax-deferred property swap. You sell one investment property and roll the proceeds into another, deferring capital gains and depreciation recapture taxes. Strict timelines apply — 45 days to identify, 180 days to close. (IRS Section 1031)
Who qualifies as a real estate professional for tax purposes? Someone who spends more than 750 hours per year in real estate activities and for whom real estate is their primary profession. This status removes the passive loss limitation, allowing rental losses to offset any type of income. Requires documentation and proper tax filing.
Sources: IRS Publication 527, Residential Rental Property; IRS Publication 544, Sales and Other Dispositions of Assets; California Franchise Tax Board; Lifetime PM, California Rental Property Tax Deductions 2026; CostSegSmart, California Bonus Depreciation 2026.
This post is for general informational purposes and is not a substitute for personalized tax advice.
