The tax implications of owning a rental property run in two directions at once: every year you report rental income and claim deductions (including a mandatory depreciation write-off) on Schedule E, and when you eventually sell you owe both capital gains tax on the profit and a separate depreciation recapture tax on the deductions you took along the way. How much of this actually applies to you depends on how you use the property, how actively you manage it, and how long you hold it before selling.
When the IRS Treats Your Property as a Rental
Section 280A of the Internal Revenue Code separates true rental property from a personal residence you happen to rent out. If you use the property personally for more than 14 days during the year, or more than 10 percent of the days it was rented at a fair price (whichever is greater), the IRS treats it as a personal residence.1Office of the Law Revision Counsel. 26 USC 280A – Disallowance of Certain Expenses in Connection With Business Use of Home, Rental of Vacation Homes, Etc Once that line is crossed, your rental expense deductions are capped at your rental income for the year. No net loss can flow through to offset other earnings.
The rule has a useful flip side. Rent the property out for fewer than 15 days in the entire year and you don’t have to report the rental income at all. You also can’t deduct rental expenses for those days, but the cash comes in tax-free. This is what makes short stays during a big local event so attractive to homeowners.1Office of the Law Revision Counsel. 26 USC 280A – Disallowance of Certain Expenses in Connection With Business Use of Home, Rental of Vacation Homes, Etc
Reporting Rental Income and Expenses
Rental income and deductible expenses go on Schedule E of your federal return. You report all rent received, including advance rent in the year you receive it (regardless of what period it covers) and any security deposit you keep or apply to a final month’s rent. Deductible expenses include mortgage interest, property taxes, insurance premiums, repairs, property management fees, and depreciation.2Internal Revenue Service. Publication 527 (2025), Residential Rental Property
Repairs Versus Improvements
The distinction matters. A repair keeps the property in its current condition, like fixing a leaky faucet or patching drywall, and is deductible in the year you pay for it. An improvement adds value or extends the property’s useful life, like a new roof or a kitchen renovation, and must be capitalized and depreciated over time. Miscategorizing either way is a common trigger for IRS scrutiny.
Depreciation Is Mandatory
Depreciation lets you deduct the cost of the building (never the land) over its useful life, even if the property is gaining market value. The Modified Accelerated Cost Recovery System sets the schedule:
- Residential rental property: 27.5 years
- Nonresidential (commercial) real property: 39 years
Both use the straight-line method with a mid-month convention, so the property is treated as placed in service at the midpoint of the month you first rent it out.3Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System For a residential building with a $300,000 depreciable basis, that comes to roughly $10,909 per year. To be treated as residential rental property, at least 80 percent of the building’s gross rental income must come from dwelling units rather than commercial tenants.2Internal Revenue Service. Publication 527 (2025), Residential Rental Property
Skipping depreciation isn’t a strategy. Whether or not you claim it, the IRS treats you as having taken it when you sell, and taxes you accordingly. So you may as well take the deduction each year.
Rental Losses Are Usually Passive
Rental income is almost always classified as passive income, and passive losses generally can’t offset wages, salary, or business income. Unused losses carry forward but stay frozen until you generate passive income to absorb them or sell the property.2Internal Revenue Service. Publication 527 (2025), Residential Rental Property
The $25,000 Active Participation Allowance
Most small landlords qualify for a significant exception. If you actively participate in managing the rental by making decisions about tenants, repairs, and lease terms, you can deduct up to $25,000 in rental losses against nonpassive income each year. The allowance begins phasing out when adjusted gross income exceeds $100,000 and disappears entirely at $150,000.4Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited A lot of landlords never claim it because they don’t know it exists.
Real Estate Professional Status
If real estate is your main job, you may escape the passive rules altogether. Real estate professional status requires more than 750 hours during the year in real property trades or businesses in which you materially participate, and those hours must exceed half of the personal services you perform across all your work during the year.5Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules Meet the threshold and your rental losses stop being passive, so they can offset any type of income with no dollar cap. The bar is high and the IRS looks hard at these claims. Keep meticulous time logs.
What Happens When You Sell
Capital Gains
Sell the property for more than your adjusted basis (original cost plus improvements, minus depreciation) and the profit is a capital gain. Held for more than a year, it qualifies for long-term capital gains rates of 0, 15, or 20 percent depending on your taxable income. For 2026, single filers cross into the 15 percent bracket at $49,450 of taxable income and hit 20 percent above $545,500. Married couples filing jointly reach 15 percent at $98,900 and 20 percent above $613,700.
Depreciation Recapture
This is the part that surprises new investors at closing. All the depreciation you claimed (or should have claimed) is “recaptured” and taxed at a maximum rate of 25 percent as unrecaptured Section 1250 gain.6Internal Revenue Service. TD 8836 – Capital Gains, Partnership, Subchapter S, and Trust Provisions The recapture is separate from and on top of the regular capital gains tax on the rest of your profit. If you owned a residential rental for 10 years and claimed roughly $109,000 in depreciation, up to $27,250 of that could go straight to the IRS before you calculate capital gains on the remainder.
Deferring the Bill With a 1031 Exchange
A Section 1031 like-kind exchange lets you roll the proceeds from one investment property into another without paying capital gains or depreciation recapture at the time of sale. The deadlines are tight: 45 days from the sale to identify replacement properties, and 180 days to close on one.7Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Miss either window and the exchange fails, leaving you with the full tax bill. Both the sold and the acquired property must be real property held for productive use or investment, so a 1031 cannot be used to move into a personal residence. A qualified intermediary must hold the funds between sale and purchase; taking possession of the money yourself disqualifies the transaction.