Owning a rental property adds complexity to your tax return, but it also unlocks one of the most powerful tools in the tax code: depreciation. This guide explains how rental income is taxed, what you can deduct, and how the passive activity loss rules affect your ability to use those deductions.
How Rental Income Is Taxed
Rental income is generally reported on Schedule E of your Form 1040 and taxed as ordinary income at your marginal federal rate (10%–37% in 2025). Unlike wages, rental income is not subject to self-employment tax — a meaningful advantage over other self-employment income.
What counts as rental income?
- Monthly rent payments
- Advance rent or security deposits you keep
- Lease cancellation payments
- Services received in lieu of rent (at fair market value)
If a tenant pays for a repair in exchange for reduced rent, that amount is income to you even though you never received cash.
The Deductions Available to Landlords
Rental property deductions fall into two broad categories: operating expenses and depreciation. Together, they can offset much or all of your rental income — and sometimes more.
Operating Expense Deductions
- Mortgage interest on the rental property
- Property taxes
- Insurance premiums (fire, liability, flood)
- Repairs and maintenance (not improvements — see below)
- Property management fees (typically 8–12% of gross rent)
- Advertising and tenant screening costs
- Professional services: Accountant, attorney fees related to the rental
- HOA dues
- Utilities you pay (common in multi-family buildings)
- Travel expenses to inspect or maintain the property (70 cents/mile in 2025)
Repairs vs. Improvements
This distinction matters a great deal. Repairs are deductible in the year incurred; improvements must be depreciated over time.
- Repair (deductible now): Fixing a broken window, patching a roof leak, repainting a unit
- Improvement (capitalize and depreciate): Adding a deck, replacing the entire roof, installing central A/C
How Depreciation Works
Depreciation is the crown jewel of rental property tax benefits. The IRS allows you to deduct the cost of the building (not the land) over its useful life as the property gradually wears out.
Residential Rental Property: 27.5 Years
Residential rental properties are depreciated over 27.5 years using the Modified Accelerated Cost Recovery System (MACRS), straight-line method.
Example:
- Purchase price: $350,000
- Land value (not depreciable): $50,000
- Depreciable building basis: $300,000
- Annual depreciation: $300,000 ÷ 27.5 = $10,909 per year
That $10,909 annual deduction reduces your taxable rental income every year for 27.5 years, even though you paid no cash. This is what makes real estate a powerful wealth-building vehicle.
Depreciation Recapture
When you sell the property, the IRS recaptures depreciation deductions at a maximum rate of 25% (the “unrecaptured Section 1250 gain” rate). This is higher than the standard long-term capital gains rate of 0%/15%/20%, so factor this into your long-term exit strategy.
Cost Segregation
A cost segregation study identifies building components that qualify for 5-year, 7-year, or 15-year depreciation instead of 27.5 years (e.g., carpeting, appliances, landscaping, parking lots). Combined with 100% bonus depreciation — restored by OBBBA for qualified property placed in service after January 19, 2025 — this can create large paper losses in the early years of ownership.
The Passive Activity Loss Rules
Here is where many landlords run into an unexpected wall. Under the passive activity loss (PAL) rules (Section 469), losses from rental activities are generally “passive” and can only offset other passive income. You cannot deduct a $15,000 rental loss against your W-2 salary — unless you qualify for an exception.
Exception 1: The $25,000 Rental Real Estate Allowance
If you actively participate in managing your rental (approving tenants, setting rents, approving repairs) and your AGI is under $100,000, you can deduct up to $25,000 in rental losses against non-passive income.
This allowance phases out by 50 cents for every dollar of AGI above $100,000, disappearing entirely at $150,000 AGI.
| AGI | Max Rental Loss Deduction |
|---|---|
| $80,000 | $25,000 |
| $100,000 | $25,000 |
| $120,000 | $15,000 |
| $140,000 | $5,000 |
| $150,000+ | $0 |
Exception 2: Real Estate Professional Status
If you spend more than 750 hours per year in real estate activities AND more than half your total working time is in real estate, you qualify as a real estate professional. Your rental activities are then treated as non-passive, and all losses can offset any income — wage income, business income, investment income.
This status is valuable for high earners who exceed the $150,000 AGI phase-out, and it’s commonly used by landlords with large portfolios or who have a spouse active in real estate.
Suspended Passive Losses
Losses you cannot use in the current year are not lost — they become suspended passive losses that carry forward indefinitely. You can use them to:
- Offset passive income in future years
- Deduct in full when you sell the property (triggering a “disposition of a passive activity”)
Real-World Cash Flow vs. Taxable Income
Rental properties often show a tax loss even when they generate positive cash flow, because depreciation is a non-cash deduction.
Example:
| Item | Cash Flow | Tax Treatment |
|---|---|---|
| Rent collected | +$24,000 | +$24,000 income |
| Mortgage payment | –$18,000 | Only interest (~$12,000) deductible |
| Property taxes | –$3,600 | –$3,600 deduction |
| Insurance | –$1,200 | –$1,200 deduction |
| Maintenance | –$1,500 | –$1,500 deduction |
| Depreciation | $0 cash | –$10,909 deduction |
| Net | –$300 cash loss | –$5,209 taxable loss |
This property generates a small cash loss but a larger paper loss thanks to depreciation — potentially sheltering other passive income from tax.
Short-Term Rentals (Airbnb, VRBO)
If you rent a property for fewer than 7 days average per guest, it may qualify as a short-term rental (STR), which the IRS can treat as an active business rather than a passive rental. This can allow losses to offset non-passive income without the real estate professional requirement — but it also means the income may be subject to self-employment tax. Consult a tax professional if you operate STRs.
Key Takeaway
Rental income is taxed as ordinary income, but depreciation and operating deductions can dramatically reduce or eliminate your taxable rental income. The passive activity loss rules limit how rental losses interact with your other income, but the $25,000 allowance, the real estate professional exception, and suspended loss carryforwards preserve the long-term value of those deductions. Use our income tax calculator to model how rental income affects your overall tax picture.