Real estate

How rental property is taxed

Rent is taxable income, but you pay tax only on what is left after expenses and depreciation, and many small landlords show little or no taxable profit. You report it on Schedule E. If the rental shows a loss, you can usually deduct up to $25,000 of it against your wages, as long as your income is under $100,000.

What counts as rental income

More than the monthly rent can be taxable.

Normal rent, when you receive it.
Advance rent: taxable in the year you receive it, whatever period it covers.
Security deposits are not income if you may have to return them. The part you keep becomes income in the year you keep it.
A payment from a tenant to cancel the lease.
Expenses a tenant pays for you, such as a repair bill, count as rent (and you can deduct the expense).

Deductible expenses

You deduct the ordinary costs of owning and running the rental.

Mortgage interest (not the principal) and points.
Property taxes and insurance.
Repairs and maintenance: fixing a leak, painting, replacing a broken window.
Management fees, advertising, legal and tax preparation fees.
Utilities you pay, HOA fees, travel to the property to collect rent or make repairs.
Depreciation of the building and of improvements (below).

Repairs vs improvements

A repair keeps the property in working order and is deducted right away. An improvement must be capitalized and depreciated: anything that makes the property better (an addition, a new kitchen), restores it (a new roof), or adapts it to a new use.

Depreciation: 27.5 years

A residential rental building is depreciated in equal amounts over 27.5 years, starting the month it is ready to rent (with a half month for that first month). Land is never depreciated, so split the purchase price between building and land.

IRS example: a house bought for $185,000, of which $160,000 is the building, placed in service in February. The first year deduction is $5,091, and about $5,818 a year after that.

Appliances, carpets and furniture are 5-year property and qualify for 100% bonus depreciation; fences and driveways are 15-year property.

Rental losses and the $25,000 allowance

Rentals are passive activities, so a loss normally can only offset passive income. The main exception:

If you actively participate (you own at least 10% and make management decisions such as approving tenants and repairs), you can deduct up to $25,000 of rental loss against wages and other income.
The $25,000 shrinks by 50 cents for each dollar of modified AGI over $100,000 and is gone at $150,000.
Married filing separately: $12,500 only if you lived apart all year (phase-out from $50,000 to $75,000); none if you lived together at any time.
Losses you cannot use carry forward and are fully released when you sell the property.
Real estate professionals who materially participate are not limited by these rules.

Renting out part of your home or a vacation home

Personal use changes the rules.

Rented fewer than 15 days in the year: you do not report the rent at all, and you do not deduct rental expenses.
If you use it personally for more than 14 days, or more than 10% of the days it is rented (whichever is greater), it counts as your home, and rental deductions are limited to rental income.
Expenses are split between rental and personal use by days.

Where to report it

Real estate rentals go on Schedule E (Form 1040). If you provide hotel-like services primarily for the tenant’s convenience, such as daily cleaning or meals, the income goes on Schedule C instead and may owe self-employment tax.

Selling a rental

Depreciation lowers your basis, so it increases your gain when you sell. The part of the gain equal to the depreciation is taxed at up to 25%; the rest is a capital gain at 0%, 15% or 20%. Depreciation you were entitled to but never claimed still reduces your basis, so claim it every year.

Illinois

Net rental income is part of your Illinois income and taxed at the flat 4.95%. Illinois property taxes on the rental are deductible as a rental expense on Schedule E.

Own a rental?

USTAXX sets up depreciation correctly, separates repairs from improvements and tracks passive losses year to year on your Schedule E. In Naperville, IL, or remotely.

Tax consulting and planning Book a consultation (847) 773-7070

Questions people ask

How is rental income taxed?

As ordinary income, after subtracting expenses and depreciation. It is reported on Schedule E and is generally not subject to self-employment tax.

How long do you depreciate a rental property?

A residential rental building is depreciated over 27.5 years on a straight line. Land is not depreciated.

Can I deduct rental losses against my salary?

Up to $25,000 a year if you actively participate and your modified AGI is $100,000 or less. The allowance phases out by $150,000.

Do I pay tax on a security deposit?

Not if you may have to return it. If you keep part of it, that part is income in the year you keep it.

What if I rent my home for less than 15 days?

The rent is not reported and is tax-free, and you do not deduct rental expenses.

Where these rules come from

General information, current when written, not advice about your situation. Fees and forms change; the official pages above are the authority.