A Tale of Two Buyers

Published On: July 10, 2026

Written by: Ben Atwater and Matt Malick

One of the most frequent questions we receive from clients is about the wisdom of purchasing investment properties. In these discussions, we often address the inherent tax and, therefore, pricing disadvantages that non-professional real estate investors face.

The tax code divides real estate investors into two groups. The first consists of real estate professionals. The second consists of passive investors. Both groups may own the same apartment building, collect the same rent, and claim the same depreciation. Yet the tax code often produces different results. The distinction rests on the owner, not the property.

Passive investors own real estate alongside another career or business. They may work as physicians, attorneys, executives, or entrepreneurs. They hire managers, review operating results, and expect the property to create wealth over time. Congress classifies rental real estate as a passive activity. As a result, rental losses usually cannot offset wages or business income, particularly for high earners.

A real estate professional follows a different path. The tax code requires more than 750 hours each year in real property trades or businesses, and those activities must account for more than half of the taxpayer’s working time. The taxpayer must also materially participate in the rental activity for the affected property. When an investor passes those tests, the rental activity may no longer receive passive treatment.

This distinction creates one of the largest tax advantages available to any class of investors.

A passive investor may report substantial tax losses because depreciation often exceeds taxable rental income. Yet those losses often do not meaningfully reduce current taxes on salary or business income. Instead, they typically carry forward until the investor earns passive income or sells the property. The deduction survives, but its value declines with time. A tax deduction that arrives ten years from now cannot match one claimed today.

Some exceptions to this differentiation do exist, such as an “active participation allowance” for certain middle-income investors and a “short-term rental exception” for those whose rental properties have short average stays (think Airbnb).

Furthermore, for couples that file joint tax returns, one spouse may meet the real estate professional requirements, and they may deduct the property losses against the other spouse’s ordinary income.

But on average, passive real estate investors receive a worse bargain than real estate professionals because they cannot deduct qualifying rental losses against ordinary income in the current year. That treatment raises taxes immediately and leaves less capital available for reinvestment. Earlier tax savings produce greater compounding than later tax savings. Time creates wealth, and the tax code gives more time to the professional.

The economic consequences reach beyond the tax return. Markets adjust to incentives. A buyer who receives greater after-tax benefits can afford to pay more for the same asset while earning the same after-tax return.

Economic theory therefore suggests that real estate professionals should bid property values higher than passive investors can justify. Sellers capture part of the tax benefit through higher prices. Passive investors not only wait years to use their deductions, but they may also pay inflated prices if tax-favored buyers compete against them. The market transfers part of the professional’s tax advantage into the purchase price.

Passive investors still enjoy important benefits. Depreciation shelters rental income. Mortgage interest, repairs, insurance, and operating expenses remain deductible. Suspended losses carry forward without expiration and often reduce taxes when the property sells. All investors, passive and professional, may also defer gains through like-kind exchanges, and current law grants heirs a step-up in cost basis if they inherit the property.

These provisions soften the burden, but they do not eliminate it. Timing matters in finance. Today a dollar invested compounds. A dollar tied up in suspended tax losses does not. The tax code recognizes the deduction but delays its economic value.

The real estate professional earns favorable treatment by devoting his working life to the business. That commitment deserves recognition. Yet the tax code extends benefits that reach beyond the individual taxpayer. Those benefits influence market prices and affect every buyer who competes for investment property.

Rarely do taxes solely determine whether an investment succeeds or fails. Purchase discipline, financing, management, and patience matter more. Even so, taxes influence asset values because investors buy after-tax cash flows, not before-tax returns. On that measure, passive investors begin the race several steps behind. They can still win, but they must overcome a tax system that favors their competition before the bidding even begins.

Disclosure: Regulators could view this communication as marketing / advertising. This commentary is written by Ben Atwater and Matt Malick and reflects only their opinions and viewpoints. Atwater Malick, LLC sources facts, figures, quotations, etc. from what they believe are reliable sources, but they cannot guarantee their reliability. In addition, this essay makes no claims as to investment performance – past, present, or future. For additional important disclosures, please click here.