Rental income is taxed as ordinary income at your regular tax rate, but you can deduct most expenses you pay to earn it
The IRS treats rental income like wages or salary — it goes on your tax return at your full marginal rate, which ranges from 10% to 37% depending on your total income. But unlike wages, you don't pay tax on the gross rent you collect. You report the rent minus your rental expenses: mortgage interest, property tax, repairs, insurance, utilities you pay, advertising for tenants, and depreciation. The difference — your net rental income — is what actually gets taxed.
This matters because a property that brings in $24,000 a year in rent might owe tax on only $8,000 or $12,000 of it, depending on your expenses. A property that loses money can create a deduction that lowers your tax on other income, though passive loss rules can limit that benefit.
Key Takeaways
- Rental income is taxed at your ordinary income tax rate, but only on the amount left after you subtract allowable expenses.
- You can deduct mortgage interest, property tax, insurance, repairs, maintenance, utilities, and depreciation, but not the principal portion of your mortgage payment.
- Depreciation is a non-cash deduction that reduces your taxable income each year, but the IRS recaptures it at a higher rate when you sell the property.
- If your rental losses exceed your rental income, passive loss rules may prevent you from deducting the excess against your wages or investment income.
- You must report rental income and expenses on Schedule E, which attaches to your Form 1040.
What counts as rental income and what doesn't
Rental income includes the monthly rent your tenants pay, plus any other money they give you for occupying the property. Security deposits are not income — they belong to the tenant and must be returned or applied to damage or unpaid rent. If you keep part of a security deposit for legitimate reasons, that portion becomes income in the year you keep it.
Payments for utilities, parking, pet fees, or late fees are all rental income. If a tenant pays you to break a lease early, that payment is also income. Prepaid rent — rent paid in advance for a future month — counts as income in the year you receive it, not the year it covers.
Expenses you can deduct and those you cannot
Deductible expenses are costs you pay to earn the rental income or keep the property in condition to earn it. The main ones are:
- Mortgage interest (not principal)
- Property tax
- Insurance premiums
- Repairs and maintenance
- Utilities you pay
- Advertising for tenants
- Property management fees
- Condo or HOA fees
- Cleaning and trash removal
- Depreciation
Non-deductible expenses include the principal portion of your mortgage payment, capital improvements (major upgrades that add value or extend the life of the building), and personal expenses. The line between a repair and a capital improvement matters: replacing a broken window is a repair; replacing all the windows is a capital improvement. Repairs are deducted in full in the year you pay for them. Capital improvements are depreciated over many years.
How depreciation works and why it matters later
Depreciation is a deduction for the wear and tear on your building over time. You cannot depreciate the land itself, only the structure and its components. The IRS assumes residential rental property loses value over 27.5 years, so you divide the cost of the building (not the land) by 27.5 and deduct that amount each year.
Depreciation is a non-cash deduction — you don't actually spend money, but you reduce your taxable income. This can be powerful: a property with $20,000 in rent and $15,000 in expenses might show a $5,000 profit, but if depreciation is $8,000, you have a $3,000 loss on paper. That loss can offset other income.
The catch is depreciation recapture. When you sell the property, the IRS taxes all the depreciation you claimed at a 25% rate, regardless of your ordinary tax bracket. If you claimed $80,000 in depreciation over ten years and sell at a gain, you owe 25% on that $80,000 ($20,000 in tax) even if your ordinary rate is 22%. This is one reason to think carefully about whether to claim depreciation in low-income years.
Passive loss rules and when rental losses don't help you
If your rental expenses exceed your rental income, you have a passive loss. Passive losses can only offset passive income — income from other rental properties or partnerships where you don't actively work. They cannot offset your wages, salary, or investment income, with one exception.
If your modified adjusted gross income is under $100,000 and you actively participate in managing the property (you make decisions about tenants, repairs, and rent), you can deduct up to $25,000 in passive losses against your ordinary income. This deduction phases out as your income rises above $100,000 and disappears entirely at $150,000. If your income is above $150,000 or you don't actively participate, unused losses carry forward to future years and can offset passive income or gains when you sell the property.
How to report rental income and expenses to the IRS
You report all rental income and expenses on Schedule E (Form 1040), which attaches to your main tax return. You list each property separately if you own more than one. Schedule E asks for the address, the type of property, the number of days it was rented, and the number of days you used it personally.
You then list all income (rent, fees, other) and all expenses in the categories the IRS provides. The form calculates your net profit or loss for each property. If you have a loss, Schedule E feeds it to your Form 1040 where the passive loss rules explore.
Keep records of all rental income and expenses for at least three years, and longer if you claim depreciation. The IRS can audit rental properties, and documentation — bank statements, receipts, repair invoices, property tax bills — is your defense.
State and local taxes on rental income
Most states tax rental income as ordinary income at their state rate. Some states have no income tax at all (Florida, Texas, Wyoming, and others), which can make a significant difference if you own property there. A few states tax capital gains at a lower rate than ordinary income, but rental income is ordinary income, not capital gains.
Local taxes vary widely. Some cities impose a rental income tax or a tax on short-term rentals. If you rent out a room or use the property as a vacation rental, check your city and county rules — some jurisdictions require licenses and impose additional taxes.
Frequently Asked Questions
Can I deduct the mortgage principal I pay on a rental property?
No. Only the interest portion is deductible. The principal is a return of your own capital and reduces your basis in the property. Your lender's statement shows interest and principal separately, so you know which to deduct.
What if I rent out a room in my home?
You report the income and can deduct a share of expenses proportional to the rented space. If one bedroom out of four is rented, you can deduct one-quarter of utilities, insurance, property tax, and repairs. Depreciation is more complex because you must depreciate only the rental portion of the building, not your personal residence.
Do I owe tax on rent I never collected because a tenant didn't pay?
No. You report rent on the cash basis — income you actually receive. If a tenant owes you $3,000 but moves out without paying, you don't report it as income. You may be able to deduct it as a bad debt, but only if you previously reported it as income, which you did not.
What happens to depreciation when I sell the rental property?
All depreciation you claimed is recaptured and taxed at 25%, even if your ordinary capital gains rate is lower. If you claimed $60,000 in depreciation and sell at a $40,000 gain, you owe 25% on the $60,000 ($15,000) plus your ordinary rate on the $40,000 gain. This is built into the calculation of your total gain.
Can I deduct a loss on a rental property against my job income?
Only if your income is under $100,000, you actively manage the property, and the loss is under $25,000. Above $100,000, passive loss rules prevent you from using rental losses to offset wages. Unused losses carry forward and can offset future rental income or gains when you sell.