Updated for tax year 2023.
Owning rental property is a source of income that impacts your tax return. Let’s dive into the Internal Revenue Service (IRS) tax rules for rental property owners to help you maximize the tax benefits and create a strategy to lower your tax bill or defer some of your taxes.
At a glance:
- Depreciation reduces your taxable net income but be aware of depreciation recapture if you decide to sell.
- Rental income is generally a passive activity, which has its own special rules.
- High income can impact your allowable loss deductions.
Depreciation deduction for rental properties and depreciation recapture
If you’ve read “get rich” real estate books, a common theme is that rental property can help you save money on taxes. The key is the depreciation deduction — a tax deduction you can take for a percentage of your cost basis in rental buildings each year. This is a valuable tax benefit, allowing you to offset taxable net income generated by your rental property. The IRS lets you depreciate the value of the property — excluding the fair market value of the land — over a 27.5-year period.
But there are some caveats to note. For instance, if you sell your rental property, all those depreciation deductions have reduced your basis in your property. Your profit when you sell is equal to your selling price minus your adjusted basis. Basically, you get the tax benefits of depreciation deductions while you own the property, but when you sell, you generally pay tax on the gain you would have had, plus all those depreciation deductions you took. This is called depreciation recapture, and it’s taxed at your ordinary income tax rate, up to a max of 25%. Your remaining profits are then taxed at capital gains tax rates.
Don’t let this scare you off, though — if depreciation deductions push some tax liability to future years, that’s not all bad. The longer you keep your money, the more it can work for you. There are also ways to avoid depreciation recapture, like making the property your primary residence for two years before you sell. Similarly, you might be able to reduce the tax impact by selling the rental property in a year when you are in a lower tax bracket or when you are selling other assets at a loss.
Beware the passive activity and at-risk rules of investment property
The IRS generally considers rental income to be a passive activity, which is subject to special rules.
For example, let’s say you had a net rental activity loss, as is very likely with the help of the depreciation deduction. Under passive activity rules, you can’t use that loss to offset your other taxable income, such as your salary. You can only use it to offset passive income.
If you (and your spouse, if you’re married) actively participate in your rental real estate activity, however, you may get a special break. Subject to income limitations, you may be able to deduct up to $25,000 of loss from the activity ($12,500 if you file as married filing separately and you lived apart from your spouse all year). You can use this loss to offset nonpassive income, such as your regular salary.
If you are a real estate professional and you meet certain requirements for time spent on rental activities, you may be able to treat your rental real estate activity as a nonpassive activity.
If your investment is not “at risk,” meaning you cannot lose some or all of the money you have in it, you cannot take a tax loss of more than the amount you have at risk. But you probably don’t need to worry about this rule unless you are a real estate investor with a more complex financial investment. Most small-time real estate investing would be categorized as fully “at risk.”
High adjusted gross income can mean no rental property loss deduction
If your modified adjusted gross income (MAGI) is between $100,000 and $150,000 or higher ($50,000 and $75,000 if married filing separately), your maximum allowable loss is reduced. You cannot take a special allowance for a rental real estate loss if your MAGI is over $150,000 ($75,000 if married filing separately). You can carry any unused loss forward until you have a year with a lower MAGI, or until the year you sell or otherwise dispose of the property.
Depreciation isn’t the only write-off you can take
Rental property owners have the option of deducting more than just depreciation. Here are a few examples of other rental property deductible expenses:
- Advertising
- Auto expenses, either the standard rate of 0.67 cents per mile in 2024 (up from 0.655 cents in 2023) or your actual expenses, such as gas, oil, and depreciation
- Cleaning
- Mortgage interest (generally reported to you on Form 1098)
- Non-mortgage interest, such as credit card interest on a card you use only for rental expenses
- Insurance, including fire, flood, liability, and mortgage insurance
- Legal fees and tax preparation fees related to your rental activity
- Maintenance
- Property management fees
- Property taxes
- Property and liability insurance
- Repairs, such as repairing the dishwasher, regular repainting, or fixing a roof leak (just make sure the repairs you claim aren’t actually capital improvements, which instead become part of your basis)
- Supplies
- Travel expenses when you travel overnight to improve property
- Utilities
When to report income
Remember that if you’re on a cash basis, as most individual taxpayers are, you report income when you receive it. This is true regardless of the period to which the rent applies.
For example, if your tenant pays you on Dec. 30, 2023, for their January 2024 rent payment, you need to report that rental income with your 2023 taxes. Unfortunately, waiting to cash the check until 2024 won’t help — you must report the income in the year the funds became available to you.
Follow special rules for security deposits
If you receive a security deposit that you expect to return to the tenant, do not report it as income. If a deposit is nonrefundable, on the other hand, you must report it as income when you receive it.
The bottom line
As a rental property owner, it’s essential to understand the tax law to maximize your tax benefits while minimizing your liabilities. Make sure you understand depreciation and its recapture implications, passive activity rules, at-risk considerations, income limitations, and deductible expenses. Staying informed and up to date on tax changes can also help you optimize your tax strategy and keep more of your rental income in your pocket.