How Is Rental Income Taxed When You Have a Mortgage?

When you own a rental property with a mortgage, the IRS taxes your net rental income: the rent you collect minus your allowable expenses. The mortgage affects that calculation in one direction only. The interest portion of each payment is deductible against rental income, and so are amortized points and property taxes actually paid out of escrow. The principal portion is not deductible at any point. Everything else that determines your bill (depreciation, passive loss rules, the surtax on high earners) sits on top of that basic split.

What Counts as Rental Income

Every dollar you receive for the use of the property is taxable in the year you receive it. That includes regular monthly rent, advance rent (if a tenant pays January and February in December, both months are December income), and the fair market value of property or services a tenant gives you instead of cash.¹

Security deposits are the exception. A deposit you intend to return isn’t income when you collect it. The moment you keep any portion (for unpaid rent, cleaning, or damage), that amount becomes taxable for the year you keep it. A deposit labeled “last month’s rent” is treated as advance rent and is taxable when received.²

What the Mortgage Lets You Deduct

Mortgage Interest

Interest paid on debt secured by the rental property is deductible against your rental income.³ Your lender reports the annual total on Form 1098, usually issued by January 31. That figure goes onto Schedule E, line 12. For most landlords, interest is the single largest mortgage-related deduction, though the share of each payment that’s interest shrinks as the loan amortizes.

Points and Loan Origination Charges

Points paid to take out or refinance a rental mortgage are prepaid interest, but you generally can’t deduct them all in year one. You spread the deduction evenly over the life of the loan. Three thousand dollars of points on a 30-year mortgage produces a $100 annual deduction.¹ If you refinance again or sell before the loan matures, the unamortized balance is deductible in that final year.

Cash-Out Refinance Interest

If you refinance for more than the remaining balance and pocket the difference, the deductibility of the interest depends on what you do with the cash. Proceeds put back into the rental or into another income-producing asset keep their interest deductible. Proceeds used for personal spending (paying off credit cards, renovating your own home) generate interest that isn’t deductible at all. The IRS applies interest tracing rules to sort this out, which makes clean records of where the money went essential.⁴

Property Taxes Paid Through Escrow

If your lender collects property taxes with your mortgage payment, only the amount actually disbursed from escrow to the taxing authority during the calendar year is deductible. Money sitting in the escrow account you haven’t yet paid out doesn’t count, even though it’s already left your bank.¹

Mortgage Costs You Cannot Deduct

Principal is the big one. The principal portion of each payment builds equity, and the IRS treats it as debt repayment rather than an operating expense, so it never reduces taxable rental income.¹

Closing costs like mortgage commissions, abstract fees, and recording fees are capital costs. They can’t be deducted as current expenses; they’re amortized over the life of the loan.¹

Private mortgage insurance is another cost that produces nothing at tax time. The PMI deduction expired after 2021 and, as of 2026, has not been reinstated. Legislation to make it permanent has been introduced but not enacted.⁵ If you’re paying PMI on a rental, it currently gives you no tax benefit.

Depreciation Usually Beats the Interest Deduction

Depreciation is often worth more than mortgage interest, and it’s easy to overlook because it involves no cash outlay. Residential rental property is depreciated using the straight-line method over 27.5 years.⁶ Land can’t be depreciated, so your depreciable basis is the cost of the property minus land value. A $300,000 purchase with $60,000 of land value gives you a $240,000 basis and roughly $8,727 per year to deduct without writing a check. Improvements you add later (a new roof, an HVAC system) get their own depreciation schedule.¹

Depreciation begins the month the property is placed in service, using a mid-month convention. Start renting in July and you claim only about half a year in year one.¹

Skipping depreciation costs you twice. When you sell, the IRS taxes you on the depreciation you claimed or could have claimed at a rate of up to 25% (unrecaptured Section 1250 gain), and it reduces your basis by the “allowable” amount whether or not you actually took the deduction.⁷ Take it every year.

When a Rental Loss Can Offset Your Other Income

Once you subtract mortgage interest, depreciation, and everything else, many rentals show a paper loss. That loss doesn’t automatically reduce your wages or business income. Rental real estate is generally a passive activity, and passive losses can only offset passive income. Unused losses carry forward until you have passive income to absorb them or you sell the property.

The $25,000 Active-Participation Allowance

If you actively participate in managing the property (approving tenants, setting rental terms, authorizing repairs), you can deduct up to $25,000 of rental losses against ordinary income each year.⁸ The allowance phases out at a rate of 50 cents per dollar once modified adjusted gross income passes $100,000, and disappears at $150,000. You need at least a 10% ownership stake, and limited partners don’t qualify regardless of ownership.⁹

Real Estate Professional Status

Qualify as a real estate professional and rental activities stop being automatically passive. You must perform more than 750 hours of service in real property businesses during the year, and that must be more than half of all the personal services you perform in any trade or business.⁸ On a joint return one spouse can meet the test alone, but you cannot combine hours. A W-2 employee with a couple of rentals on the side will rarely qualify.

The 3.8% Surtax and the 20% QBI Deduction

Higher-income landlords owe an extra 3.8% Net Investment Income Tax on the lesser of net investment income or the amount by which modified AGI exceeds $200,000 (single) or $250,000 (married filing jointly).¹⁰ Net rental income, after mortgage interest and depreciation, sits inside that calculation. Real estate professionals who materially participate may be exempt from NIIT on their rental income.¹¹

Working the other direction is Section 199A, which lets eligible taxpayers deduct up to 20% of qualified business income. The IRS created a safe harbor for rental real estate: perform at least 250 hours of rental services per year, keep contemporaneous logs, and your rental is treated as a business for QBI. For properties held four or more years, the 250-hour test needs to be met in three of the past five.¹² A rental can also qualify under general trade-or-business principles, but that determination is fact-specific.

Personal Use Can Undo the Whole Setup

If you use the property yourself for more than the greater of 14 days or 10% of the days it’s rented at fair price, the IRS reclassifies it as a residence. Your deductions are then capped at the amount of rental income, which effectively wipes out any rental loss.¹³ Personal use days include time by family members, co-owners, or anyone paying below-market rent. The reverse rule also matters: rent the place for fewer than 15 days in the year and the rental income is entirely tax-free (and the expenses aren’t deductible).

How to Report It

Rental income and expenses flow through Schedule E (Form 1040), Part I. Gross rent goes on line 3, mortgage interest on line 12, and depreciation and other expenses on their respective lines. The net figure carries to your Form 1040 and becomes part of your adjusted gross income.¹⁴

Form 1098 from your lender is the primary source document for mortgage interest, points, and any mortgage insurance premiums. If your lender doesn’t issue one, total the interest from your monthly statements yourself. Check your original Closing Disclosure as well, because amortizable points and certain capitalized fees often don’t appear on the 1098.

1
Internal Revenue Service. Publication 527 – Residential Rental Property
2
Internal Revenue Service. Rental Income and Expenses – Real Estate Tax Tips
3
Office of the Law Revision Counsel. 26 USC 163 – Interest
4
Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
5
Congress.gov. HR 918 – 119th Congress (2025-2026) Mortgage Insurance Tax
6
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
7
Internal Revenue Service. Property (Basis, Sale of Home, Etc.) 5
8
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
9
Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
10
Office of the Law Revision Counsel. 26 USC 1411
11
Internal Revenue Service. Net Investment Income Tax
12
Internal Revenue Service. IRS Finalizes Safe Harbor to Allow Rental Real Estate to Qualify as a Business for Qualified Business Income Deduction
13
Internal Revenue Service. Renting Residential and Vacation Property
14
Internal Revenue Service. About Schedule E (Form 1040), Supplemental Income and Loss