All About Taxes on Rental Income

If you own an investment property and collect rent from your tenants, that rental income will be part of your taxes. You can, however, deduct expenses you incur to maintain your rental property. In other words, becoming a landlord for the first time will make filing your taxes more complex but there are tax advantages that can save your money. 

A financial advisor can advise you on the best tax strategy for your real estate and other investments. 

Taxes on Rental Income: What to Declare

The rental income you declare on your income taxes will depend on your method of accounting. Most individuals use the “cash basis method.” This method requires you to report income as you receive it and expenses as you pay them out. But some businesses use the “accrual” method of accounting. This counts income when it’s earned, not when it’s received.

If you’re just a private citizen with a rental property, you’ll probably use the cash basis method. That means you’ll count rent money that you receive as income in the relevant tax year. The IRS also says that you can also include advance rent, which the agency defines as any amount that you collect from a tenant before the period that it covers when using this method. So, if you sign a two-year lease with a tenant, and you get the first-year rent payments with some payments for the following year, then you would report all of these payments as rental income in the tax year that you received them.

You may also be able to count the security deposit that your tenant provides. You can do so if you use the security deposit as a final rent payment or you take all or part of it as compensation for damage done by tenants. But if you take a security deposit intending to return that deposit when the tenant leaves, don’t count the deposit as income.

When a tenant makes an in-kind payment, you can also report it as taxable income according to the number of months it covers. For example, let’s say you agree with a tenant to accept a good or service from them in exchange for one month’s rent. In the eyes of the IRS, you have still received a month’s rent. This means you’ll need to report that month’s rent as income when you file your taxes.

There are some other forms of rental income landlords should report. For example, if a tenant pays you to get out of a lease, that payment counts as rental income for tax purposes. You’ll need to report that payment in the year you receive it, no matter your method of accounting. If your tenant pays any building expenses not required per the lease terms, those payments also count as income. It will also count as income if a tenant pays for a repair or utility not required in the lease and then deducts that payment from his or her rent payment.

What You Can Deduct to Reduce Your Tax Liability

It might sound like being a landlord and collecting rent is a big tax headache. But remember that you can also deduct expenses to shrink your tax liability. You can deduct costs like the mortgage interest on your rental property, property taxes, operating expenses, repairs and depreciation.

The IRS uses the standard of “ordinary and necessary expenses” to determine what you can deduct. Ordinary expenses are no-brainers expenses that generally come with owning a rental property. This includes the payments you make to a management company or superintendent. Necessary expenses can include costs like advertising vacancies or covering maintenance expenses, utilities and insurance. You can also deduct the cost of materials, supplies, and repairs made to maintain your building.

What you can’t fully deduct in a single year, however, is money spent on improvements to your rental property. While routine maintenance and repairs are deductible as operating expenses, improvements such as renovations, remodels or major upgrades are considered capital expenditures. These costs are recovered over time through depreciation rather than claimed as a full deduction in the year incurred. Understanding the difference between repairs (immediately deductible) and capital improvements (depreciated over time) helps you properly claim deductions and avoid IRS issues.

You can deduct depreciation of your property and its features like appliances. If you make improvements, you can recoup some of the money you spend when you file new depreciation paperwork. To do so, you’ll use IRS Form 4562.

How to Report Taxes on Rental Income

To report your rental income, you’ll use Form 1040 and attach Schedule E: Supplemental Income and Loss. On Schedule E, you’ll list your total income, expenses and depreciation for each rental property. Expenses include advertising, auto and travel, insurance, repairs, taxes, and more. Again, you’ll need Form 4562 to correctly fill in the amount of depreciation on line 18 “Depreciation expense or depletion.”

A single Schedule E form allows you to report on three properties. If you have more than three, you can file additional Schedule E forms to list your other properties on Lines 1 and 2. However, you will only fill in the “Totals” column on one Schedule E form. These totals will be the combined totals of all the Schedules E you file.

To ensure you provide the IRS with the correct information, you’ll want to keep records of your property management transactions. This includes rent checks, financial statements, receipts, deductible expenses and more. If you can’t provide the correct paperwork and information, you may not be able to deduct as much as you’d like. Even worse, you could face additional taxes and penalties.

Passive Activity Loss Rules and Income Limits

Rental income is generally treated as a passive activity for income tax purposes, which affects how losses can be used. While rental properties may generate deductible expenses that exceed rental income, those losses are not always allowed to offset other types of income, such as wages or business earnings.

The IRS provides a limited exception for certain landlords who actively participate in managing their rental property. Under this rule, eligible taxpayers may be able to deduct up to $25,000 in rental losses against non-passive income, depending on their filing status and level of involvement. ¹ This allowance is subject to income limits and begins to phase out as adjusted gross income increases.

Income thresholds play a central role in determining whether rental losses can be deducted in the current year. As income rises above the phaseout range, the amount of allowable loss is reduced and may eventually be eliminated. Any disallowed losses are not lost, but instead carried forward to future tax years.

Carried-forward passive losses can be used in later years when rental income increases or when the property is sold. At that point, suspended losses may offset rental income or, in some cases, other income, which can affect the overall tax outcome of owning and eventually disposing of a rental property.

How Depreciation Works and Why It Matters for Rental Property Owners

Depreciation is one of the most valuable tax benefits available to rental property owners, and one of the most frequently misunderstood. It lets you deduct a portion of the property’s cost each year to account for wear and tear, even if the property is gaining value in the market.

How the Calculation Works

Residential rental property is depreciated over a 27.5-year period in equal annual installments. Your starting point is the cost basis, typically the purchase price plus certain closing costs, minus the value of the land. Land cannot be depreciated because it does not deteriorate over time. Only the structure and qualifying improvements are eligible.

If you purchase a rental property for $300,000 and the land accounts for $50,000 of that value, your depreciable basis is $250,000. Spread over 27.5 years, that produces an annual deduction of roughly $9,090. This reduces your taxable rental income each year without any additional out-of-pocket spending, which is what makes it one of the more powerful benefits in the tax code for property owners.

What Counts as Depreciable

Beyond the building itself, certain components and improvements may qualify for depreciation on a shorter timeline. Appliances, carpeting and some fixtures can often be written off over a shorter period than the structure. For owners of larger properties, a cost segregation study can identify which elements of the building qualify for accelerated depreciation, front-loading those deductions into earlier years and improving near-term cash flow.

Depreciation Recapture at Sale

What many landlords do not anticipate is the tax consequence of depreciation at the time of sale. The IRS treats the accumulated depreciation you claimed as income when you sell, a process called depreciation recapture. That recaptured amount is taxed at a federal rate of up to 25%, which sits above the long-term capital gains rate applied to the rest of the property’s gain.

Using the earlier numbers, ten years of depreciation at $9,090 per year produces $90,900 in accumulated deductions. At the 25% recapture rate, that adds roughly $22,725 in federal tax at the point of sale, on top of any capital gains tax owed on the property’s appreciation.

Planning for this liability well before a sale gives you time to evaluate options. A 1031 exchange, for example, allows you to roll the proceeds from a sale into a new investment property, deferring both capital gains and depreciation recapture until a future sale. Knowing the recapture obligation exists is the first step toward deciding whether that kind of strategy makes sense for your situation.

Bottom Line

Owning a rental property can generate supplemental income and build long-term wealth, but success depends on meticulous financial management. From tracking expenses to documenting depreciation claims, landlords must maintain detailed records to maximize deductions and minimize tax surprises. When it comes time to sell, understanding your projected tax liability upfront prevents costly miscalculations. Working with a tax professional ensures your records are audit-ready and your tax strategy is optimized throughout your ownership.

“Rental income can be an excellent source of supplemental income. However, it is imperative that you keep accurate books and records that can substantiate expenses and any depreciation claims. For those that are thinking about selling, you should run a tax projection to ensure you know your projected tax bill,” said Matthew Hofacre, MSPFP, CFP®, EA.

Matthew Hofacre, MSPFP, CFP®, EA provided the quote used in this article. Please note that Matthew is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinion voiced in the quote is for general information only and is not intended to provide specific advice or recommendations.

Tips for Filing Your Taxes

• A financial advisor can potentially help you manage your rental income and answer other tax questions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Filing your taxes can be a tricky business. If you find yourself confused or overwhelmed, as could be the case if you’re a landlord, you could use tax software. This will help you get your calculations and taxes in order, without the hassle.
• If you find yourself consistently receiving a large tax refund, there is a way you can get that money during the year instead of in one check. You can do this by adjusting the amount withheld from each paycheck.

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