How Is Rental Income Calculated: Deductions, Depreciation, and Lender Rules

Rental income is calculated two different ways depending on who is asking. For your federal tax return, you take the gross rent you collected, subtract allowable operating expenses, subtract depreciation, and report the result on Schedule E. For a mortgage application, a lender either multiplies the gross monthly rent by 75% or starts from the net figure on your Schedule E and adds back non-cash deductions like depreciation. The same property can produce very different numbers under the two methods, which is why understanding both matters before you file a return or apply for a loan.

What Counts as Gross Rent

Before either calculation works, you need the right top-line number. The IRS defines rental income broadly to include any payment for the use of your property, not just the monthly check.¹ The items that catch people out:

Advance rent counts in the year you receive it. If a tenant pays first and last month at signing, both are income this year, even though the last month may not be “earned” for years.¹
A payment from a tenant to cancel a lease early is rent.¹
Services or property received instead of rent count at fair market value. If a tenant paints in exchange for two months’ rent, report those two months as income and deduct the same amount as a painting expense.¹
Expenses a tenant pays on your behalf, like a water bill or a property tax installment, are rental income to you.¹
A security deposit is not income when collected, as long as you plan to return it. The portion you keep for damage or unpaid rent becomes income in the year you keep it. If the deposit is designated as the last month’s rent, the IRS treats it as advance rent and you report it right away.¹

The 14-Day Rule for a Home You Also Live In

If you use a home as your personal residence and rent it out for fewer than 15 days during the year, you report none of that rental income and deduct none of the associated rental expenses.² Cross the 15-day threshold and the whole rental period becomes taxable.

Deductible Operating Expenses

Ordinary and necessary costs of running the property reduce your taxable rental income. The IRS allows deductions for insurance, mortgage interest, property taxes, advertising, management fees, utilities you pay, legal and accounting fees, and repairs.¹ Property management typically runs 8% to 12% of monthly rent and is fully deductible.

Repairs Versus Improvements

A repair keeps the property in its current condition and is deducted in full the year you pay for it. An improvement makes the property better, restores it to like-new condition, or adapts it for a new use, and must be capitalized and depreciated. The IRS applies a three-part test: an expense is an improvement if it results in a betterment, a restoration, or an adaptation.¹

Fixing a leaky faucet is a repair. Replacing the plumbing system is an improvement. If the work enlarged the property, increased its capacity, or replaced a major structural component, treat it as an improvement.

Two safe harbors simplify close calls. The de minimis safe harbor lets you immediately deduct items costing $2,500 or less per invoice, or $5,000 with audited financial statements, even if the item would technically be an improvement.³ The routine maintenance safe harbor covers work you reasonably expect to perform more than once every ten years, such as repainting or replacing carpet.

Depreciation

Depreciation is usually the biggest deduction on a rental, and it is not optional. The IRS requires you to depreciate the cost of the building, not the land, over 27.5 years using the straight-line method.¹ A $220,000 building produces roughly $8,000 in yearly deductions.

The mandatory piece matters. When you sell, the IRS treats you as though you claimed depreciation whether you did or not. Every dollar of depreciation claimed or allowable is taxed at sale as unrecaptured Section 1250 gain, at a maximum rate of 25%.⁴ Skipping the deduction during ownership does not avoid recapture, so there is no reason to leave it on the table.

Putting the Tax Number Together

The formula is gross rent minus operating expenses minus depreciation equals net rental income or loss. Report the figures on Part I of Schedule E, which has dedicated lines for each income and expense category.⁵ The net figure flows into your return and is taxed at ordinary income rates, which for 2026 range from 10% to 37%.⁶

Rental income on Schedule E is generally not subject to self-employment tax. The exception is when you provide substantial services primarily for tenants’ convenience, such as daily cleaning or meals, which moves the activity to Schedule C and triggers self-employment tax.⁷ Standard landlord tasks like collecting rent, screening tenants, and arranging repairs do not cross that line.

When a Rental Loss Doesn’t Reduce Your Other Income

If expenses and depreciation exceed rent, the resulting loss does not automatically offset your salary or business income. The IRS classifies most rental activity as passive, and passive losses generally only offset passive income.⁸

The main exception for ordinary landlords is the $25,000 special allowance. If you actively participate in the rental, which the IRS defines broadly enough to include approving tenants, setting rental terms, and authorizing repairs, you can deduct up to $25,000 of rental losses against non-passive income. The allowance phases out as modified adjusted gross income rises above $100,000, dropping by 50 cents per dollar of MAGI over the threshold, and disappears entirely at $150,000. For married taxpayers filing separately who lived apart all year, the allowance is $12,500 and phases out between $50,000 and $75,000.⁸

How Lenders Calculate Rental Income

Lenders are trying to answer a different question: how much cash does the property actually generate that you can use to service debt? They use two methods depending on how much history you have.

The 75% Rule

When a borrower does not yet have a full year of rental history on tax returns, lenders take gross monthly rent from a current lease or a market rent estimate and multiply it by 75%. Both Fannie Mae and Freddie Mac require this treatment, and the 25% reduction is meant to absorb vacancy and maintenance.⁹ A unit renting for $2,000 produces $1,500 in qualifying income under this method.

The Schedule E Add-Back Method

For borrowers with rental history on their returns, lenders start with the net income on Schedule E and add back non-cash deductions and items already counted elsewhere in the loan file. Fannie Mae specifically requires adding back depreciation, mortgage interest, homeowners’ association dues, taxes, and insurance.⁹ Non-recurring expenses can also be added back with documentation. The adjusted figure is then averaged over 12 months to produce a monthly qualifying number.

The reasoning: depreciation is a paper deduction that never left your bank account, and mortgage interest, taxes, and insurance are already being counted against you separately in your debt-to-income ratio. Adding them back avoids penalizing you twice.

What Lenders Want to See

Documentation depends on whether the rental is the property being financed or a separate investment you already own. For the subject property, Fannie Mae requires an appraisal-based market rent estimate: Form 1007 for single-family homes and Form 1025 for two- to four-unit properties.⁹ You will also typically provide one of the following:

Your most recent signed federal tax return with Schedule E, or
A fully executed lease supported by either two consecutive months of bank statements showing rental deposits, or copies of the security deposit and first month’s rent check with proof of deposit for a new lease.⁹

For rental income from other properties you already own, the standard documentation is your tax return with Schedule E, or IRS Form 8825 if the property is held through a partnership or S corporation.⁹

The same return drives both calculations. Aggressive deductions that minimize taxable income also shrink the net figure a lender sees, and the add-backs only recover the specific items on the list. Clean, organized records help on both sides.

1
Internal Revenue Service. Publication 527 (2025), Residential Rental Property
2
Internal Revenue Service. Topic No. 415, Renting Residential and Vacation Property
3
Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
4
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
5
Internal Revenue Service. 2024 Instructions for Schedule E – Supplemental Income and Loss
6
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
7
Internal Revenue Service. Topic No. 414, Rental Income and Expenses
8
Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
9
Fannie Mae. B3-3.8-01, Rental Income