Real estate income is taxed federally in two stages: while you own the property, your net rental profit is taxed at your ordinary income rates and treated as passive income; when you sell, your profit is taxed at long-term capital gains rates of 0%, 15%, or 20% if you held the property more than a year, with a separate 25% rate applied to the portion of the gain that represents depreciation you claimed along the way. Deductions, depreciation, passive loss limits, and a possible 3.8% surtax all sit between the rent check and the tax bill, so the effective rate on real estate income rarely matches the headline rate.
What Counts as Rental Income
Gross income under federal law includes income from any source, and rent is no exception.1Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined Your taxable rental income begins with every dollar of rent you collect, and it includes advance rent. A last-month payment collected at lease signing is reported in the year you receive it, not the year the lease ends.2Internal Revenue Service. Topic No. 414, Rental Income and Expenses
Security deposits are different. When you receive one, it isn’t income, because you owe it back. The moment you keep any portion (say, $1,200 applied to damage after a tenant moves out), that kept portion becomes income in the year you keep it.3Internal Revenue Service. Rental Income and Expenses – Real Estate Tax Tips Non-cash rent counts too. If a tenant paints your building in exchange for a month of free rent worth $1,000, you report $1,000 as rental income.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property
Deductible Expenses
Your tax bill lives in the gap between rent collected and expenses deducted. Schedule E of Form 1040 lays out the standard categories: mortgage interest, property taxes, insurance, management fees, repairs, advertising, utilities, and legal or accounting fees.5Internal Revenue Service. Schedule E (Form 1040) – Supplemental Income and Loss What survives after those deductions is the net rental income that flows to your 1040.
Repairs Versus Improvements
A repair keeps the property in the condition it’s already in. Patching a roof leak, fixing a broken window, or repainting a wall are all repairs, and you deduct the full cost the year you pay it.6Internal Revenue Service. Depreciation and Recapture 4 An improvement makes the property better, adapts it to a new use, or restores it after a major event. Central air, a new roof, or a full plumbing replacement all fall on the improvement side. Those costs get capitalized and depreciated over years rather than deducted at once.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property
There is a shortcut for smaller items. The de minimis safe harbor election lets you immediately deduct items costing $2,500 or less per invoice instead of capitalizing them. Most single-unit appliances and small equipment purchases fit under that ceiling. You make the election on the year’s return.7Internal Revenue Service. Tangible Property Final Regulations
Depreciation Is Not Optional
Depreciation is the largest non-cash deduction available to a landlord, and the IRS requires you to claim it. If you don’t, the agency still treats your basis as if you had, which means you get taxed on phantom depreciation when you sell.8Office of the Law Revision Counsel. 26 USC 167 – Depreciation
Residential rental property is depreciated straight-line over 27.5 years. Nonresidential real property uses a 39-year recovery period. Land is not depreciable, so you split your purchase price between the building and the land first. Buy a rental house for $500,000 with $100,000 attributed to land, and your depreciable basis is $400,000. That yields roughly $14,545 in depreciation each year, which lowers taxable rental income dollar for dollar.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property
Why Rental Losses May Not Reduce Your Other Income
Rental real estate is passive by default, no matter how many hours you spend on it. Passive losses can’t offset active income like wages or business profits. They get suspended and carried forward until you either generate passive income to absorb them or sell the property in a fully taxable transaction, at which point all the suspended losses come loose at once.9Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
The $25,000 Allowance
If you actively participate in managing your rental (approving tenants, setting rents, authorizing repairs), you can deduct up to $25,000 of rental losses against non-passive income each year. The allowance phases out $1 for every $2 of modified AGI above $100,000, and it’s gone at $150,000.9Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules For married taxpayers filing separately who lived apart all year, the allowance is $12,500 with the phase-out starting at $50,000.10Internal Revenue Service. Instructions for Form 8582 (2025)
Real Estate Professional Status
Qualifying as a real estate professional removes the passive limitation entirely. You need more than 750 hours during the year in real property businesses in which you materially participate, and those activities must account for more than half of all your working hours.9Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules In practice, that means full-time property managers, agents, or developers, not someone with a day job who handles a rental on evenings and weekends.
Short-Term Rentals
If the average guest stay is seven days or less, the IRS doesn’t treat the activity as a rental at all. It’s a regular business, and if you materially participate, losses are fully deductible against other income without needing the $25,000 allowance or professional status.9Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
Other Taxes and Breaks Tied to Rental Income
The Qualified Business Income Deduction
Rental owners operating through a sole proprietorship, partnership, or S corporation may deduct up to 20% of net rental income under Section 199A, extended by the One, Big, Beautiful Bill Act signed in July 2025. The activity has to rise to the level of a trade or business. The IRS provides a safe harbor for landlords who log at least 250 hours of rental services during the year (or in at least three of the last five years for properties held more than four years), keep contemporaneous time records, and maintain separate books for each rental enterprise.11Internal Revenue Service. IRS Finalizes Safe Harbor to Allow Rental Real Estate to Qualify as a Business for Qualified Business Income Deduction Above certain inflation-adjusted income thresholds, W-2 wage and depreciable basis limits kick in.
The 3.8% Net Investment Income Tax
Higher-income landlords owe an extra 3.8% on net investment income, and rental profit counts. The tax applies when modified AGI exceeds $200,000 for single filers, $250,000 for joint filers, or $125,000 for married filing separately, and it’s imposed on the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.12Internal Revenue Service. Topic No. 559, Net Investment Income Tax The thresholds are fixed in statute and don’t adjust for inflation.
Self-Employment Tax Generally Does Not Apply
Standard rental income from real estate is not subject to self-employment tax. Federal regulations exclude real estate rentals from net earnings from self-employment even when managing the property takes real effort.13Social Security Administration. 404.1082 Rentals From Real Estate; Material Participation Two exceptions: real estate dealers who hold property primarily for sale to customers owe SE tax on rentals from that inventory, and providing substantial services to tenants (daily maid service, meals, boarding-house arrangements) can convert the income into business income subject to SE tax.
What Happens When You Sell
A sale triggers a separate set of rules. Hold the property one year or less, and the gain is short-term, taxed at ordinary income rates. Hold it longer than a year, and the gain qualifies for long-term capital gains rates of 0%, 15%, or 20% depending on total taxable income.14Internal Revenue Service. Topic No. 409, Capital Gains and Losses Most sellers land at 15%.
Depreciation Recapture at 25%
Your gain is not all taxed at the same rate. The depreciation you claimed (or should have claimed) gets recaptured at a maximum rate of 25%, higher than the 15% most sellers pay on the rest.15Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed This is unrecaptured Section 1250 gain, and it’s the IRS clawing back the tax benefit of years of depreciation deductions.
An example makes it concrete. You buy for $500,000, take $50,000 in depreciation, and sell for $600,000. Adjusted basis is $450,000, so total gain is $150,000. The first $50,000 (the depreciation piece) is taxed at up to 25%. The remaining $100,000 is taxed at your long-term capital gains rate. Sellers who budget only 15% on the whole gain are the ones surprised at closing.
Deferring or Excluding the Sale Tax
Section 1031 Like-Kind Exchange
Reinvesting the sale proceeds into another investment property through a Section 1031 exchange defers both the capital gains tax and the depreciation recapture. Since the Tax Cuts and Jobs Act, the provision applies only to real property.16Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips Two deadlines are rigid and cannot be extended:
- 45 days from the sale to identify potential replacement properties in writing.
- 180 days from the sale to close on the replacement, or by your return due date with extensions, whichever comes first.
A qualified intermediary must hold the proceeds during the exchange. If the money touches your account, the exchange fails. Any cash or non-qualifying property you receive (known as boot) is taxable even if the rest qualifies.17Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 The tax isn’t eliminated. It’s deferred until you eventually sell without exchanging again, at which point the entire chain of deferred gain becomes taxable.
Converting to a Primary Residence
Section 121 lets you exclude up to $250,000 of gain ($500,000 for joint filers) on the sale of a home you’ve owned and lived in as your principal residence for at least two of the five years before the sale. For a former rental, though, the exclusion is reduced proportionally for any period of “nonqualified use,” which includes the years the property was rented after 2008. Own for 10 years, rent for 6, live in it for 4, and roughly 60% of the gain is allocated to the rental period and can’t be excluded.18Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence And regardless of the exclusion, depreciation recapture at 25% still applies to depreciation claimed during the rental years. That piece is never excludable.
How All This Gets Reported
Rental income and expenses go on Schedule E of Form 1040, line by line for each property, with the net figure flowing to your main return.19Internal Revenue Service. About Schedule E (Form 1040), Supplemental Income and Loss If passive losses are limited, Form 8582 calculates the allowable deduction.10Internal Revenue Service. Instructions for Form 8582 (2025)
A sale expands the paperwork. Form 4797 handles the sale itself and computes depreciation recapture.20Internal Revenue Service. About Form 4797, Sales of Business Property The resulting gain or loss moves to Schedule D, which summarizes all capital transactions before the final number lands on Form 1040.21Internal Revenue Service. Schedule D (Form 1040) 2025 Misreported depreciation recapture and mishandled passive loss carryovers are among the more common audit triggers for rental owners, and the mistakes compound across the years you hold the property.