Owning rental property means navigating one of the most nuanced corners of the US tax code — one that’s simultaneously more generous and more complex than most people expect. This guide covers the full scope: how rental income is taxed from the day you place a property in service through the day you sell it, how short-term and long-term rentals are treated differently, and the specific rules that determine how much you actually owe.
We’ve organized this as a reference guide you can return to throughout the year — not just at filing time.
The Core Concept: Ordinary Income on Net Profit
Rental income is taxed as ordinary income under federal law. It’s reported on Schedule E and added to your other income sources — wages, interest, dividends — and taxed at your marginal rate, which ranges from 10% to 37% depending on total taxable income.
But ‘ordinary income’ doesn’t mean you pay tax on every dollar collected. You pay tax only on net rental income — what’s left after subtracting every allowable deduction from your gross receipts. For most landlords, especially those who take full advantage of depreciation, the taxable portion of rental income is significantly lower than the cash collected.
Short-Term Rentals vs. Long-Term Rentals: Tax Differences That Matter
Most rental income is classified as passive activity regardless of whether you’re running a long-term lease or a short-term rental. But the tax rules that apply — particularly around how losses can offset other income — differ based on the nature of the rental and your level of involvement.
Long-Term Rentals
Traditional long-term rentals (leases of 30 days or more) are automatically classified as passive activity under IRS rules. This means rental losses — when deductions exceed income — can generally only offset other passive income, with limited exceptions based on your income level and participation (discussed in detail below). The income is reported on Schedule E.
Short-Term Rentals
Short-term rentals — those where the average guest stay is seven days or fewer — are treated differently. They are not automatically classified as passive activity. Instead, they may be classified as an active business if the owner materially participates in day-to-day operations, which opens the door to using losses against any income, including wages. This is a significant tax distinction that can dramatically change the benefit of depreciation deductions for high-income landlords.
Short-term rentals are also reported on Schedule E (not Schedule C, which is for self-employment), unless you provide substantial services to guests — like daily cleaning, concierge, or meals — which would make it closer to a hotel business and trigger self-employment tax.
The 14-Day Personal Use Rule
If you rent a property for 14 or fewer days in the year, the income is not taxable and does not need to be reported. Above 14 rental days, the income is taxable. If you also use the property personally, the number of personal use days relative to rental days affects which expenses you can deduct and in what proportion.
What Every Landlord Can Deduct
The IRS permits deductions for all ordinary and necessary expenses incurred in managing and maintaining a rental property. These fall into two categories: current deductions (claimed fully in the year incurred) and capital expenditures (depreciated over time).
Current-Year Deductions
Mortgage interest- the interest component of your mortgage payment is deductible; the principal payment is not. Your lender’s year-end Form 1098 shows the total interest paid.
Property taxes on the rental property are deductible in full as a business expense. Unlike primary residences (subject to the $10,000 SALT cap for itemizers), rental property taxes face no such limit.
Insurance premiums for landlord, fire, flood, liability, and umbrella coverage on the property are all deductible. Property management fees, advertising costs, repair and maintenance expenses, legal and accounting fees related to the rental, and travel to the property for management or maintenance purposes are also deductible.
Capital Expenditures: Depreciated Over Time
Expenses that improve the property — rather than maintain it — must be capitalized and deducted gradually through depreciation. The distinction: a repair restores something to its prior condition; an improvement adds value, extends useful life, or adapts the property to a new use.
A replaced broken window is a repair. A complete window replacement throughout the property with energy-efficient models is an improvement. A patched roof section is a repair. A full roof replacement is an improvement. The full cost of improvements is recovered over time through depreciation rather than as a single deduction.
Depreciation: The Non-Cash Deduction You Cannot Afford to Skip
Depreciation allows you to deduct the declining value of the building (not the land) over its useful life as defined by the IRS. For residential rental properties, that useful life is 27.5 years. Each year, you deduct 1/27.5th of the building’s depreciable basis — approximately 3.6% — regardless of whether the property is actually losing value in the market.
This is a non-cash deduction. No money leaves your account. But it directly reduces your taxable rental income, often turning what would be a taxable profit into a tax-neutral or even loss position on paper, even while the property generates positive cash flow.
Accelerated Depreciation
A cost segregation study can accelerate depreciation by reclassifying components of the property — appliances, flooring, certain fixtures, landscaping, parking surfaces — from the 27.5-year schedule to 5-, 7-, or 15-year schedules. Under current law, assets with recovery periods of 20 years or fewer placed in service after January 19, 2025 qualify for 100% bonus depreciation, allowing the entire cost to be deducted in the first year rather than over the assigned depreciation period.
Depreciation Recapture: What Happens When You Sell
Depreciation deductions taken during ownership are recaptured when you sell the property. The IRS taxes accumulated depreciation at a maximum rate of 25% — a separate calculation from the capital gains tax on the property’s appreciation.
It’s important to understand that the IRS calculates recapture based on depreciation ‘allowed or allowable’ — meaning the tax applies to all depreciation you were entitled to claim, whether or not you actually claimed it. Skipping depreciation during ownership to avoid future recapture tax doesn’t work; you’ll owe the recapture regardless and will have missed the annual deduction benefit.
Example: You purchase a rental property for $400,000 ($320,000 building value). Over 10 years of ownership, you take $116,364 in depreciation. When you sell, $116,364 is subject to recapture tax at up to 25% — that’s approximately $29,091 in recapture tax. But you saved significantly more than that on your annual income tax over 10 years by claiming the deduction. The math almost always favors taking depreciation.
Passive Activity Rules by Income Level
Understanding passive activity rules is essential to knowing how useful your rental deductions actually are each year.
Under $100,000 MAGI
If you actively participate in managing your rental property — meaning you approve tenants, set rental terms, and authorize repairs, even if you use a property manager for day-to-day tasks — you can deduct up to $25,000 in rental losses against ordinary income annually. This full allowance applies when your modified adjusted gross income is $100,000 or below.
$100,000 to $150,000 MAGI
The $25,000 special allowance phases out proportionally as income rises from $100,000 to $150,000. At exactly $125,000 MAGI, $12,500 of the allowance remains. At $150,000, it disappears entirely.
Above $150,000 MAGI
Above this threshold, standard passive rental losses cannot offset ordinary income — they accumulate and carry forward to future years, where they can offset rental income or capital gains at the time of sale. The exception: landlords who qualify as real estate professionals (750+ hours per year in real estate activities, comprising more than 50% of their total work time) can deduct rental losses against any income, with no income cap.
Capital Gains Tax on Rental Property Sales
When you sell a rental property held for more than 12 months, the gain on the sale is subject to long-term capital gains tax — separate from and generally lower than ordinary income rates. The applicable rates are 0%, 15%, or 20% based on your total taxable income and filing status.
Your taxable gain is calculated as: net sale price (after selling costs) minus your adjusted basis. Adjusted basis is your original purchase price plus the cost of improvements, minus the total depreciation you’ve claimed. Because depreciation reduces your basis, every dollar of depreciation taken during ownership reduces your basis and therefore increases the gain subject to tax at sale — a key reason why depreciation recapture is calculated separately.
Net Investment Income Tax
Taxpayers with MAGI above $200,000 (single) or $250,000 (married filing jointly) may also owe an additional 3.8% Net Investment Income Tax (NIIT) on net rental income and capital gains from rental property sales. This is separate from both ordinary income tax and capital gains tax.
Strategies to Defer or Reduce Sale Tax
A 1031 exchange defers both capital gains and depreciation recapture tax by rolling sale proceeds into a qualifying replacement property. Identification must happen within 45 days of closing and the replacement must be purchased within 180 days. Properly executed, a 1031 exchange defers all tax indefinitely — and if the property is held until death, heirs receive a stepped-up basis that may eliminate the deferred tax entirely.
An installment sale — where the buyer pays over multiple years — spreads capital gains across tax years, potentially keeping each year’s income in a lower bracket. This is particularly useful when a lump-sum sale would push a large gain into the 20% capital gains bracket or trigger NIIT.
Frequently Asked Questions
Do I owe self-employment tax on rental income?
No — rental income is passive income, not self-employment income, and is not subject to Social Security or Medicare taxes. This is one of the meaningful tax advantages of rental property over self-employment or freelance income.
What if my rental property operates at a loss every year?
Losses that can’t be used currently due to passive activity rules don’t disappear — they accumulate and carry forward. They can offset future rental income, reduce capital gains at sale, and in the year of a complete disposition of the property, any remaining suspended losses may be deducted in full.
Does putting the property in an LLC change how income is taxed?
For a single-member LLC, no — it’s a disregarded entity and income flows to your personal return exactly as it would from a personally held property. For a multi-member LLC taxed as a partnership, each member reports their share on a Schedule K-1. The rate of tax is unchanged; only the reporting structure differs.
What records should I keep?
Keep receipts and bank records for all income received and all expenses paid. Maintain a mileage log for property-related travel. Track improvements separately from repairs. Retain purchase documents, depreciation schedules, and cost basis records for the life of the property plus at least three years after sale.
RPM Bakersfield maintains organized monthly income and expense records for every property we manage — giving you clean, audit-ready documentation and a complete year-end summary that makes tax preparation straightforward. Contact us for a free rental property evaluation.
This content is provided for general informational and educational purposes only and does not constitute financial, legal, tax, or investment advice. Readers should consult with licensed professionals regarding their specific circumstances.
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