Rental property creates taxable income, but it also generates a set of deductions that can reduce or eliminate the tax owed on that income. The challenge is that the tax rules governing rental property are more complex than those for a primary residence. The passive activity rules limit when you can use rental losses to offset other income. The depreciation rules create deductions now but trigger recapture taxes when you sell. And the repair-vs-improvement distinction determines whether a payment is immediately deductible or must be capitalized and deducted over years. Getting these details right has a direct impact on your tax bill every year. IRS Publication 527 is the authoritative source for residential rental property tax treatment.
What counts as rental income for tax purposes
All income received from tenants is taxable, including:
- Monthly rent payments
- Advance rent received for future periods (taxable in the year received, not the year it applies to)
- Security deposits that you apply toward unpaid rent or damages
- Payment for canceling a lease
- Services a tenant performs in lieu of rent
Security deposits are not taxable when received if you intend to return them. They become taxable income in the year you apply them to rent or damages.
Rental income is reported on Schedule E of your federal tax return. If you have more than one rental property, each property gets its own Schedule E entry. The total net income or loss from all rental properties carries forward to your Form 1040.
Key takeaway
A security deposit becomes taxable income in the year you apply it, not the year you receive it. If you receive a $1,800 deposit in December and hold it through the following year, you report nothing on this year's return. If you apply $900 to cover unpaid rent in March of next year, that $900 becomes taxable income in that year.
Operating expenses landlords can deduct: the full list
IRS Publication 527 identifies the following categories of deductible rental expenses:
| Expense category | Notes |
|---|---|
| Mortgage interest | Interest only, not principal; from Form 1098 |
| Property taxes | State and local real estate taxes on the rental |
| Insurance premiums | Landlord insurance / fire / liability; not life insurance |
| Repairs (ordinary and necessary) | Restoring property to original condition (see section below) |
| Property management fees | Fees paid to a property manager |
| Advertising and leasing costs | Vacancy ads, tenant screening fees |
| Professional services | Attorneys, accountants, tax preparation fees for the rental |
| Travel to the property | Actual vehicle expenses or standard mileage rate for rental-related trips |
| Utilities paid by landlord | If you pay water, trash, or other utilities |
| Home office | Proportional share of home expenses if office is used exclusively for rental management |
| Depreciation | Annual deduction for wear and tear (see below) |
Expenses must be ordinary (common in the rental business) and necessary (appropriate for the rental activity) to qualify. Personal expenses that benefit you as well as the rental are not deductible or must be allocated.
How depreciation works on rental property and how to calculate it
Depreciation is the annual deduction that accounts for the wear and tear on a rental property over time. For residential rental property, the IRS allows you to deduct the depreciable basis over 27.5 years using the straight-line method.
Step 1: Determine your cost basis. Start with the purchase price, add acquisition costs (title insurance, legal fees, recording fees paid by the buyer), and add any capital improvements made before the property was placed in service.
Step 2: Separate land from improvement value. Land is not depreciable. Use the property tax assessor's allocation between land and improvements, or obtain a separate appraisal if the ratio appears unreasonable.
Step 3: Calculate annual depreciation. Divide the depreciable basis (total basis minus land value) by 27.5.
For example: A property purchased for $280,000 with $8,000 in acquisition costs has a total basis of $288,000. The assessor allocates 20 percent to land ($57,600). The depreciable basis is $230,400. Annual depreciation is $230,400 / 27.5 = approximately $8,378 per year.
Depreciation begins when the property is placed in service -- meaning available for rent -- not when you purchased it. The first and last years of ownership use a mid-month convention that prorates the deduction.
Repairs vs. improvements: the distinction that determines deductibility
This is one of the most consequential distinctions in rental property taxation.
Repairs restore the property to its original working condition. They are fully deductible in the year paid. Examples: fixing a broken window, patching a roof leak, replacing a broken appliance, repainting interior walls after a tenant moves out.
Improvements add value, extend useful life, or adapt the property to a new use. They must be capitalized -- added to your property's basis -- and deducted over their useful life, not all at once. Examples: adding a new room, replacing the entire roof, installing a new HVAC system, adding a deck, upgrading a kitchen.
The IRS uses a "betterment, restoration, or adaptation" framework under the Tangible Property Regulations. If a repair is part of a plan of rehabilitation -- for example, if you are gutting and renovating a unit -- even individually repair-like items may need to be capitalized. Document the purpose and scope of any significant work carefully.
Warning
The repair-vs-improvement distinction is one of the most frequently audited areas of rental property taxation. Keep invoices and photographs for every significant maintenance expense. If you are undertaking a multi-trade renovation affecting structure, roof, HVAC, plumbing, or electrical systems simultaneously, consult a tax professional before deciding how to categorize the costs. Misclassification creates both an understated deduction (if improvements are called repairs) or a deduction you will have to repay (if repairs are treated as improvements and later reclassified).
Passive activity rules: when you can deduct rental losses
Rental income and losses are generally treated as passive activity under the IRS rules established in the Tax Reform Act of 1986. Passive losses can ordinarily only offset passive income -- you cannot use a rental property loss to offset your W-2 wages.
There are two important exceptions:
The $25,000 active participation allowance. If your adjusted gross income (AGI) is below $100,000 and you actively participate in your rental activity -- meaning you make management decisions, approve tenants, and set rental terms yourself, even if you hire a manager -- you can deduct up to $25,000 of rental losses against non-passive income such as wages. The allowance phases out at $50 for every $1 of AGI above $100,000 and disappears completely at $150,000 AGI.
Real estate professional status. If more than 50 percent of your working hours are in real estate activities and you perform more than 750 hours of real estate services per year, rental losses are not subject to the passive activity limits. This applies to a small subset of landlords -- typically those in the real estate business full time.
Passive losses that cannot be used in the current year are "suspended" and carry forward. They can be used against future passive income or freed up entirely when the property is sold in a fully taxable transaction.
How to report rental income and expenses on Schedule E
Schedule E is a supplemental schedule attached to Form 1040. For each rental property, you report the address, the number of days it was rented and used personally, rental income, and itemized expenses across about 20 categories. The net income or loss from each property is calculated on Schedule E and flows to your Form 1040 adjusted gross income.
If you own more than three rental properties, you attach additional pages of Schedule E. If your rental activity is classified as a business (typically only if you provide substantial services to tenants, such as in a bed and breakfast), it may be reported on Schedule C instead.
Keep a separate set of records for each property: rental income received by date, all expense receipts, the depreciation schedule showing each year's deduction, and a log of any personal use days if you also use the property personally.
What happens to tax treatment when you sell a rental property
Selling a rental property triggers three tax calculations:
Depreciation recapture: The depreciation you deducted over the years reduces your cost basis. When you sell, the IRS recaptures the gain attributable to depreciation at a federal rate of up to 25 percent. This applies even if you sell at a loss on the total purchase price.
Capital gains tax: Any gain above your adjusted basis (after depreciation recapture) is taxed as a capital gain. The long-term rate applies if you held the property more than one year: 0 percent, 15 percent, or 20 percent depending on your income, according to current IRS tax rate schedules.
Suspended passive losses: If you have accumulated suspended passive losses from prior years, the full sale of the property frees them for use against ordinary income in the year of sale.
The primary residence exclusion ($250,000 single / $500,000 married) does not apply to a rental property that has not also been your primary residence for at least 2 of the 5 years before the sale. A 1031 exchange, which allows you to defer capital gains by reinvesting proceeds into a like-kind property, is available for investment properties but is governed by strict timing and identification rules.
Working with a tax professional experienced in real estate before you sell is worth the cost. The depreciation recapture calculation is straightforward but the interaction with suspended losses, the 1031 option, and installment sale reporting can be complex depending on your situation.
See Property Management Fees Explained: What You Actually Pay for how management fees factor into your annual rental expense deductions.
See How to Screen a Tenant: A Landlord's Checklist for the documentation practices that support your tenant-placement expense deductions and protect you in an audit.
Frequently asked questions
Can I deduct mortgage payments on a rental property?
The mortgage principal payment is not deductible. The mortgage interest portion is deductible as a rental expense on Schedule E. Your Form 1098 from the lender shows the total interest paid for the year. Interest is typically the largest component of payments in the early years of a loan, which is also when it provides the most deduction value for the landlord.
How many years do I depreciate a rental property?
Residential rental property is depreciated over 27.5 years using the straight-line method under IRS Publication 527. You divide the depreciable basis (purchase price plus acquisition costs minus land value) by 27.5 to get the annual depreciation deduction. Land is never depreciable. Commercial rental property uses a 39-year life. Depreciation begins when the property is placed in service, not when you purchased it.
What is the $25,000 passive activity loss allowance?
If your adjusted gross income is below $100,000 and you actively participate in managing your rental, you can deduct up to $25,000 in rental losses against non-passive income like wages. The allowance phases out between $100,000 and $150,000 AGI. Above $150,000, passive rental losses can only offset passive income -- they cannot offset wages or self-employment income until the property is sold.
Can I deduct home office expenses if I manage my own rentals?
You may deduct a home office used regularly and exclusively for rental management activities as a rental business expense. The deduction is calculated as a percentage of your home's square footage used for the office, applied to eligible home expenses. IRS Publication 587 governs home office rules. The regular-and-exclusive-use requirement is strictly interpreted; a room that doubles as a guest bedroom does not qualify.
What receipts should I keep for rental property taxes?
Keep receipts and records for every expense you claim: mortgage interest statements (Form 1098), property tax bills, repair invoices, insurance premium statements, property management fee invoices, utility bills, travel to the property, and professional service fees. IRS Publication 527 recommends keeping records for at least 3 years from the return due date. Keep depreciation records for the life of ownership plus 3 years after sale because depreciation recapture applies when you sell.
Do I owe depreciation recapture when I sell a rental?
Yes. Depreciation claimed reduces your cost basis, and the IRS recaptures it at up to 25 percent on the gain attributable to depreciation -- separate from the capital gains rate. This applies even if you did not take the deduction; the IRS treats you as having claimed it. Work with a tax professional when selling a rental property to plan for this liability.