Owning rental property can be a smart wealth-building tool, but it also comes with important tax responsibilities.
The rules for reporting rental property on your taxes are very different from your personal return, and many property owners find themselves overwhelmed by what they can (and can’t) deduct, how to report losses, and how to handle capital gains if they sell.
The good news? With the right approach, rental property owners can often reduce their taxable income and avoid costly mistakes. Let’s break down what you need to know about handling taxes if you own rental property.
Understanding How Rental Income Is Taxed
If you rent out property, the IRS expects you to report all the income you receive. This includes the rent payments you collect from tenants and also other forms of rent-related income. For example, if a tenant covers an expense that you are responsible for (say, they pay a repair bill and deduct it from the rent), that amount must be counted as rental income on your return. Even the fair market value of services or property given in lieu of rent is considered rental income. For instance, if your tenant is a painter who paints the house instead of paying one month’s rent, you’d include the equivalent rent amount as income.
Rental income is considered ordinary income, which means it’s taxed at your normal tax rate. But unlike a paycheck, it doesn’t have taxes automatically withheld, so you’re responsible for making sure it gets reported correctly.
Common Types of Rental Income
Monthly rent payments: Your primary rental income.
Advance rent: If a tenant pays the first and last month upfront, you must report it the year you receive it.
Security deposits kept: If you keep all or part of a deposit, it counts as taxable income.
Tenant-paid expenses: If your tenant covers an expense (like utilities) that you’d normally pay, the IRS considers it rental income.
Tip: Most individual landlords use Schedule E (Form 1040) to report rental income and expenses for each property. On Schedule E, you list the rents you received and all the deductible expenses for each rental. After deductions (including depreciation), the net profit or loss from each property flows into your Form 1040 taxable income. Also, note that rental income is generally not subject to Social Security or Medicare taxes, unlike self-employment income. However, high-income investors should be aware that net rental income can be subject to the 3.8% Net Investment Income Tax if your income exceeds certain thresholds (for example, $250,000 for joint filers.
What You Can Deduct as a Rental Property Owner
This is where owning rental property gets more favorable.The IRS allows you to deduct “ordinary and necessary” expenses you incur in managing, conserving, and maintaining the property. Most costs associated with operating the rental are tax-deductible. Here are some of the most common deductible expenses for landlords:
Mortgage interest: One of the biggest deductions for landlords.
Property taxes: Fully deductible each year.
Repairs and maintenance: Fixing leaks, repainting, replacing broken appliances.
Insurance premiums: Landlord policies or rental property insurance.
Utilities: If you pay for water, gas, or electricity.
Property management fees: Deductible if you hire a manager or service.
Professional fees: Legal advice, accounting, or tax preparation.
The IRS also allows you to depreciate the cost of the building (not the land) over 27.5 years. Depreciation is a powerful tax tool because it gives you a yearly deduction even if you didn’t spend money out of pocket.
Repairs vs. Improvements: Why the Difference Matters
Not all property expenses are treated the same.
One big exception to be aware of: you generally cannot deduct the cost of improvements to the property as an immediate expense. The IRS makes a distinction between repairs and improvements as:
Repairs keep the property in working condition (fixing a broken window, patching a roof leak). You can deduct these in full the year they happen.
Improvements add long-term value or extend the property’s life (new roof, remodeling a kitchen). These must be depreciated over time.
Misclassifying expenses can raise red flags, so this is an area where having a tax professional really helps.
Passive Activity Rules and Rental Losses
Rental real estate is generally considered a passive activity for tax purposes. That means you usually can’t use losses from rental property to offset other types of income, like your salary.
But there are exceptions:
Active participation exception
If you own at least 10% of the property and make management decisions (like approving tenants or setting rent), you may deduct up to $25,000 in rental losses against other income. This phases out if your income is over $100,000 and disappears at $150,000.
Real estate professionals
If rental activity is your main business and you spend over 750 hours a year managing it, you may qualify to treat losses differently.
Understanding where you fall in these rules is crucial, especially if your property is losing money in the early years.
Selling a Rental Property: Capital Gains and Depreciation Recapture
If you eventually sell your rental property, taxes don’t end at closing. You’ll likely owe capital gains tax on the profit, and you may also face depreciation recapture.
Capital gains tax applies to the difference between your selling price and your adjusted basis (purchase price plus improvements, minus depreciation).
Depreciation recapture means the IRS will tax the depreciation you claimed (or could have claimed) as ordinary income when you sell.
You may be able to defer taxes through a 1031 exchange, which lets you reinvest proceeds into another rental property. But the rules are strict, so it’s important to plan ahead.
Recordkeeping Best Practices for Landlords
With all the income and deductible expenses involved in rental property, keeping good records is essential. Organized recordkeeping will help you prepare accurate returns and substantiate your deductions in case of an audit.
Here are some best practices for rental property recordkeeping:
Separate Accounts: Keep your rental income and expenses separate from your personal finances. Consider using a dedicated bank account or credit card for your rental activity.
Save All Receipts and Documents: Maintain a file for each property. Save invoices, receipts, canceled checks, or bills for every expense – repairs, supplies, property tax bills, insurance statements, etc. If you’re ever asked to prove an expense, you’ll need that documentation. For income, keep copies of lease agreements, rent receipts, or bank statements showing rent deposits.
Mileage and Travel Log: If you drive to your property or incur travel expenses for it, keep a log. Write down the date, purpose, and miles driven (or keep a mileage tracking app). For any overnight travel, keep receipts and note the purpose (e.g., “Flew to City X to oversee major repair on rental property”).
Track Depreciation and Basis: Keep a schedule of your property’s depreciable basis and depreciation taken each year. Also keep records of improvements (with dates and costs). This will be crucial when you sell the property to calculate gain and depreciation recapture.
Use Accounting Tools: Consider using bookkeeping software or even a simple spreadsheet to track income and expenses for each property by category.
Document Everything: If you ever face an IRS audit of your rental activities, good records are your best defense. You should be able to identify the source of every deposit and support every deduction with evidence. The IRS can disallow deductions that you can’t substantiate. So, hang on to those records for at least 3-6 years (at minimum, three years after filing the return, or longer if you have losses carrying forward).
State and Local Taxes
Don’t forget that rental income may also be subject to state income taxes (depending on where you live) and local property taxes. Some cities even charge additional rental licensing fees. These can sneak up on property owners if you’re not prepared.
Common Mistakes Rental Property Owners Make
Even experienced landlords can slip up at tax time. Here are some frequent errors:
Forgetting to report tenant-paid expenses as income.
Deducting improvements as repairs.
Not depreciating the building correctly.
Missing out on travel deductions for trips to the property.
Failing to track passive activity losses properly.
Any of these can lead to paying more than you owe - or worse, getting audited.
Final Thoughts
Owning rental property can be rewarding, but the tax side often catches people off guard. Between tracking income, classifying expenses, managing depreciation, and planning for eventual sales, it’s easy to miss opportunities or make costly mistakes.
Take the guesswork out of rental property taxes with the help of AMG Finance. Our tax prep specialists handle all the details so you can manage your investment.
Contact AMG Finance today and let us handle your rental property tax prep.
