Taxes When You Buy a Rental Property

Buying rental property changes your tax return significantly. You'll gain access to deductions — including depreciation — that can reduce your taxable income, but you'll also face a set of rules governing how and when rental losses can offset your other income.

All rental income must be reported on Schedule E — this includes monthly rent, security deposits that aren't returned to tenants, prepaid rent, and any other payments received in exchange for use of the property. Against that income, you can deduct all "ordinary and necessary" expenses directly related to the rental: mortgage interest, property taxes, insurance, repairs and maintenance, property management fees, advertising, HOA fees, utilities you pay, and professional fees. These deductions are "above the line" on Schedule E, not subject to the 2% floor or other limitations that apply to some itemized deductions.

One of the most powerful features of rental property is depreciation — a non-cash deduction that allows you to deduct a portion of the property's cost each year as it "wears out." Residential rental property is depreciated over 27.5 years using straight-line depreciation. On a $300,000 property (excluding land, which isn't depreciable), that's approximately $10,909 of annual depreciation deductions — a significant non-cash deduction that can turn a cash-flow-positive property into a tax loss on paper. Cost segregation studies can accelerate depreciation on certain components of a property, generating even larger early-year deductions.

The catch is the passive activity loss rules. For most landlords, rental activities are considered passive, and passive losses can only offset passive income — not wages or investment income. There's a limited exception: if you actively participate in managing the property and your modified AGI is under $100,000, you can deduct up to $25,000 of rental losses against ordinary income. This $25,000 special allowance phases out between $100,000 and $150,000 of MAGI and disappears entirely above $150,000. Suspended passive losses carry forward indefinitely and can be used when you have sufficient passive income in the future, or they become fully deductible when you sell the property in a taxable transaction.

Real estate professionals who spend more than 750 hours per year in real estate activities (and more hours in real estate than any other occupation) can treat their rental activities as non-passive, which unlocks the ability to deduct rental losses against ordinary income without limitation. When you eventually sell a rental property, you'll face both capital gains tax on the appreciation and depreciation recapture — the IRS taxes back the depreciation you claimed at a maximum rate of 25%, which applies even if your regular capital gains rate is lower. A 1031 exchange can defer both the capital gains tax and the depreciation recapture by rolling the proceeds into a like-kind replacement property.