Rental income is taxed as ordinary income at your regular tax rate, not as capital gains

When you rent out a property, the IRS treats the money you collect as ordinary income. You report it on your tax return at the same rate as wages or salary — not at the lower capital gains rate you would pay if you sold the property. This applies whether you rent a single room, a house, or multiple properties.

The IRS requires you to report all rental income, including rent paid in cash, partial payments, security deposits that you keep (not returned to the tenant), and payments for utilities or services the tenant covers instead of you. You cannot straightforward report the net amount after expenses — you report the gross rental income first, then subtract your deductible expenses to arrive at your taxable profit.

Most rental income gets reported on Schedule E (Form 1040), which is the form for rental real estate, royalties, and other supplemental income. You attach Schedule E to your main Form 1040 tax return. The profit or loss from Schedule E then flows to your main return and is taxed at your ordinary income tax bracket.

Key Takeaways

  • Rental income is taxed as ordinary income at your regular tax rate, regardless of how much you earn or how many properties you own.
  • You must report all rental income received, including cash payments and amounts the tenant pays directly to third parties on your behalf.
  • You report gross rental income on Schedule E, then subtract deductible expenses like mortgage interest, property tax, repairs, and insurance to find your taxable profit.
  • Depreciation of the building (not the land) reduces your taxable income each year, but you must recapture that depreciation when you sell the property.
  • If you have a loss after deducting expenses, passive activity loss rules may limit how much you can deduct in a given year.

What counts as rental income you must report

Rental income includes any payment you receive for the use of the property. This covers the obvious: monthly rent. But it also includes late fees, pet fees, parking fees, and any other charges you collect from the tenant. If a tenant pays you in cash, you still report it — the IRS does not exempt cash payments from taxation.

Security deposits are not rental income when you collect them, because you are holding them for the tenant. However, if you keep part or all of a security deposit because of damage or unpaid rent, that amount becomes rental income in the year you decide to keep it. If you return the deposit, you report nothing.

If a tenant pays a utility bill or property tax that you would normally pay, or if they make a repair you would normally make, the fair market value of that payment counts as rental income. For example, if a tenant paints the exterior in exchange for a rent reduction, you report the value of that work as income.

Deductible expenses that reduce your taxable rental income

Once you report gross rental income, you subtract the expenses you paid to earn that income. Common deductible rental expenses include mortgage interest (not principal), property tax, insurance, utilities you pay, repairs and maintenance, property management fees, advertising to find tenants, and legal fees related to the rental.

You can also deduct depreciation, which is a non-cash deduction. The IRS lets you deduct a portion of the building's cost each year over 27.5 years (for residential rental property). You cannot depreciate the land itself, only the building. Depreciation is calculated on Form 8949 or Schedule E, depending on your situation, and it reduces your taxable income even though you did not spend cash that year.

Expenses you cannot deduct include capital improvements (which must be depreciated instead), mortgage principal payments, personal expenses, and improvements that add value to the property beyond normal maintenance. The line between a repair (deductible) and an improvement (capitalized) matters: fixing a roof leak is a repair; replacing the entire roof is an improvement.

How depreciation works and what happens when you sell

Depreciation allows you to deduct a portion of the building's cost each year, reducing your taxable rental income. For a residential rental property, you divide the building's cost by 27.5 years. If the building cost $275,000, you can deduct $10,000 per year in depreciation.

The catch is depreciation recapture. When you sell the property, the IRS requires you to add back all the depreciation you deducted over the years and tax it at a 25 percent rate, which is higher than the long-term capital gains rate. If you depreciated $100,000 over ten years, you owe 25 percent tax on that $100,000 when you sell, even if the property did not increase in value.

This means depreciation is not "free" — it defers tax to the year you sell. For some taxpayers, taking depreciation still makes sense because you reduce your taxable income in years you own the property. For others, especially those in low tax brackets, skipping depreciation might be better. You can elect not to claim depreciation, but once you claim it, you cannot go back and un-claim it in prior years.

Passive activity loss rules and income limits

If your rental expenses exceed your rental income, you have a passive activity loss. Passive activity losses are generally limited — you cannot deduct them against wages, salary, or other active income in the same year. Instead, you carry the loss forward to future years when you have rental income, or until you sell the property.

There is one exception: the $25,000 passive activity loss allowance. If you actively participate in managing the rental property (making decisions about repairs, tenant selection, and rent amounts) and your modified adjusted gross income is below $100,000, you can deduct up to $25,000 of passive losses against your other income. This allowance phases out between $100,000 and $150,000 of income.

Real estate professionals — people who spend more than half their working hours in real estate and work in the field for more than 750 hours per year — are not subject to passive activity loss limits. If you may have access to as a real estate professional, your rental losses can offset your other income without restriction. This is a complex information, and you should consult a tax professional if you think you might may have access to.

Self-employment tax and rental income

Rental income from a property you own is generally not subject to self-employment tax. You do not pay Social Security and Medicare taxes on rental profit the way you would on self-employment income from a business.

However, if you provide substantial services to tenants — for example, you operate a hotel, a furnished short-term rental with daily maid service, or a boarding house where you provide meals — the IRS may classify your income as business income rather than rental income. Business income is subject to self-employment tax. The distinction depends on the facts: how much personal service you provide, how often you change tenants, and whether the property is primarily a place to live or a service business.

Reporting rental income on your tax return

You report rental income and expenses on Schedule E (Form 1040), Part I, which is titled "Income or Loss From Rental Real Estate and Royalties." You list each property separately if you own multiple rentals. For each property, you enter the address, the type of property (single-family home, apartment, etc.), and the number of days it was rented at fair market value versus personal use days.

On Schedule E, you list all rental income in the income section, then list all deductible expenses in the expense section. The form provides lines for common expenses like advertising, auto and travel, cleaning and maintenance, insurance, mortgage interest, repairs, taxes and licenses, utilities, and depreciation. If you have expenses that do not fit a specific line, you can list them under "Other."

The profit or loss from Schedule E flows to your main Form 1040 return. If you have a net profit, it is added to your other income and taxed at your ordinary income tax rate. If you have a net loss, it is subject to the passive activity loss rules described above. You must file Schedule E even if you have a loss, because the IRS needs to see the calculation.

Record-keeping and documentation you need

The IRS does not require you to submit receipts with your tax return, but you must keep them for at least three years (six years if you underreport income by 25 percent or more). Keep records of all rental income: lease agreements, bank deposits, cancelled checks, and any other proof of payment.

For expenses, keep receipts, invoices, and bank statements showing what you paid. For depreciation, keep the original purchase documents, the allocation of purchase price between land and building, and a record of the depreciation you claimed each year. If you claim a home office deduction or use part of your home for rental purposes, keep photos and measurements showing the space.

Organize records by year and by property. A straightforward spreadsheet tracking income and expenses by month is helpful, but the original documents are what the IRS wants if you are audited. Digital copies are acceptable as long as they are clear and complete.

Frequently Asked Questions

Do I have to report rental income if I only rent out a room in my house?

Yes. Any rental income, whether from a room, a basement apartment, or a detached property, must be reported on Schedule E. The amount does not matter — even small amounts of rental income are taxable. You can deduct expenses proportional to the space rented, such as a percentage of utilities, property tax, and insurance.

What if I rent the property for only part of the year?

You report only the income and expenses for the months it was rented. If you rented a vacation home for four months and used it personally for two months, you report income only for the four rental months. Expenses are allocated based on the number of days rented versus personal use days.

Can I deduct losses if I rent out a property at a loss?

Losses are deductible, but subject to passive activity loss limits. You can carry losses forward to offset future rental income, or deduct up to $25,000 per year against other income if you actively manage the property and meet income requirements. Losses above $25,000 are carried forward to future years.

Do I owe taxes on a security deposit I collect from a tenant?

Not when you collect it — it is held in trust. If you return the full deposit, you report no income. If you keep part of it for damage or unpaid rent, that amount becomes rental income in the year you decide to keep it. Document the reason you kept it in case the tenant disputes it.

What is the difference between a repair and an improvement for tax purposes?

A repair fixes something to keep it in working condition and is deductible in the year you pay for it. An improvement adds value or extends the life of the property and must be depreciated over time. Fixing a leaky faucet is a repair; replacing all plumbing is an improvement. When in doubt, consult a tax professional.