How US rental income is taxed: Schedule E, depreciation and losses

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Kooky

Builder of Shaka, the payment router that pays every agent their commission on closing date.

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A rented house in the United States produces two results each year: the cash the owner actually keeps, and the figure that goes on the federal tax return. The two rarely match. Depreciation lowers the taxable figure without a dollar leaving the bank account, a loss on paper may or may not be usable against a salary, and a few weeks of family holidays in the property can change which rules apply at all.

This guide follows the federal rules as the Internal Revenue Service (IRS) sets them out in Publication 527 on residential rental property, Publication 925 on passive activities, its tax topics on rental income and the instructions to Schedule E. It covers what counts as rental income, which costs are deducted, how a building is depreciated, what happens when the owner also uses the home, how losses are limited, how the year is reported and what the depreciation means on the day of sale. The amounts are those of the 2025 editions, used to prepare 2025 returns, which were the editions published by the IRS on 10 October 2026. State income taxes are a separate matter and are not covered.

IRS Publication 527 (2025), Publication 925 (2025) and Topic no. 415; federal rules for 2025 returns.

What counts as rental income

The IRS starts from a wide definition. Topic no. 414 describes rental income as cash, or the fair market value of property or services, received for the use of real estate. Monthly rent is the obvious part. Several other payments are treated the same way.

Advance rent is taxed when it arrives. Topic no. 414 says it is generally included in income in the year it is received, whatever period it covers and whatever accounting method the owner uses. Publication 527 gives an example: an owner signs a ten-year lease in March 2025 and receives US$9,600 for the first year and US$9,600 as rent for the last year. The whole US$19,200 is 2025 income.

A security deposit is different, because it may have to be handed back. The IRS says it is not income when the owner may be required to return it at the end of the lease. It becomes income in the year the owner keeps it, for instance because the tenant broke the lease. A deposit that is meant to serve as the final payment of rent is advance rent, and is counted when received. Where part of a deposit is kept for damage, Topic no. 414 ties the treatment to the owner's own practice: the amount is income if the owner deducts the cost of the repairs as an expense.

Three further cases are named in the same sources. A payment from a tenant to cancel a lease is rent in the year it is received. An expense of the owner that the tenant pays is rental income, and the owner may then deduct it if it is a deductible rental expense. And when a tenant pays in kind, the fair market value counts. Publication 527 uses a house painter who paints the property in place of rent: the owner reports that amount as income and deducts the same amount as a painting cost.

Timing follows the accounting method. Topic no. 414 notes that most individuals use the cash method, counting income when it is actually or constructively received and expenses when they are paid. Publication 527 adds that income is constructively received when it is made available to the owner. One consequence is spelled out: a cash-method owner cannot deduct rent that a tenant never paid, because that rent was never counted as income.

Which expenses come off the rent

Publication 527 lists the usual deductions: advertising, auto and travel, cleaning and maintenance, commissions, depreciation, insurance, interest, legal and professional fees, local transport, management fees, mortgage interest, points, repairs, taxes and utilities. They are generally deducted in the year they are paid.

The clock starts earlier than the first tenancy. According to Publication 527, expenses can be deducted from the time the property is made available for rent, and an owner may go on deducting the ordinary and necessary costs of managing, conserving or maintaining a property, depreciation included, while it sits vacant. What cannot be deducted is the rent that was not earned during the vacancy.

Some lines have their own rules in the publication:

• Insurance paid ahead. A premium that covers more than one year is deducted only for the part that belongs to each year.
• Travel. The cost of a trip is deductible when its main purpose is collecting rent or managing, conserving or maintaining the property, and is not when its main purpose is improving it. The standard mileage rate was 70 cents a mile for 2025.
• Points. Points paid to obtain a mortgage are prepaid interest and are generally spread over the life of the loan. In the publication's example, US$1,500 of points on a 30-year loan of US$100,000 gives US$50 a year on a straight-line basis.
• Local benefit taxes. Charges for works that raise the value of the property, such as streets, sidewalks or sewer systems, are generally not deductible and are added to the property's basis.

Repairs or improvements

The line between a repair and an improvement decides whether a cost is deducted at once or recovered over years. Topic no. 414 describes repairs as expenses that keep the property in good working condition without adding to its value; they are generally deductible. An improvement, Publication 527 says, must be capitalised, which means it is added to the property and depreciated.

The publication gives three tests. A cost is an improvement when it results in a betterment, restores the property, or adapts it to a new or different use.

• A betterment fixes a defect or condition that existed before, enlarges or expands the property, or increases its capacity, strength or quality.
• A restoration replaces a substantial structural part, repairs casualty damage after the basis has been adjusted for the loss, or rebuilds the property to a like-new condition.
• An adaptation alters the property to a use that is not consistent with the ordinary use intended when the owner began renting it.

Publication 527 illustrates the idea with a table of examples, among them an added bedroom or garage, a new roof, a furnace, a water heater, a modernised kitchen, new flooring and a fence.

Two reliefs soften the rule. If an owner elects the de minimis safe harbour for a tax year, small costs covered by it are not capitalised and may be deducted on line 19 of Schedule E. A second safe harbour, for routine maintenance, lets certain costs be deducted even where they would otherwise count as an improvement. Publication 527 does not print the dollar limits of the de minimis election on its page; it sends the reader to the agency's questions and answers on the tangible property regulations.

Depreciation: 27.5 years, and never the land

Depreciation is the deduction that most separates the tax result from the cash result. Publication 527 allows it when four conditions are met: the taxpayer owns the property, uses it in a business or income-producing activity, the property has a determinable useful life, and it is expected to last more than one year.

Land fails the third condition. The publication states that land cannot be depreciated because it generally does not wear out, become obsolete or get used up, and that the costs of clearing, grading and landscaping are usually part of the cost of land. Only the building, and the items in and around it, are recovered.

Deductions begin when the property is placed in service, which the publication defines as the moment it is ready and available for rent. A house that is ready in July but finds its first tenant in September is placed in service in July. They continue while the property is temporarily idle, for example between two tenants, and stop when the basis has been fully recovered or the property is retired from service.

Residential rental property falls under the Modified Accelerated Cost Recovery System, known as MACRS. Its general depreciation system must be used unless the law requires the alternative system or the owner elects it; that election is made in the first year and, in the words of Publication 527, can never be revoked.

The building itself is depreciated by the straight-line method with what the IRS calls the mid-month convention: whatever the day, the property is treated as placed in service in the middle of that month, so the first year gets a part-year deduction. The percentages are printed in the publication's Table 2-2d. Its example is a building with a basis of US$160,000 placed in service in February: the first-year rate is 3.182 per cent, and the deduction is US$5,091.

Splitting the price between land and building

Because only the building is depreciated, the starting figure, the basis, has to be built and then divided.

Publication 527 says the basis of a purchased property is its cost, debt taken over included. A buyer who pays US$60,000 in cash and takes over a mortgage of US$240,000 has a basis of US$300,000. Some closing costs are added: abstract fees, charges for installing utility services, legal fees, recording fees, surveys, transfer taxes, title insurance, and amounts the seller owed that the buyer agrees to pay. Others are left out: fire insurance premiums, rent or occupancy charges before closing, charges connected with getting the loan, and amounts placed in escrow for future taxes and insurance.

For the division, the publication uses the values a local tax assessor puts on each part. In its example, a house and its land are bought for US$200,000. The latest assessment values the whole at US$160,000, of which US$136,000 is the house and US$24,000 the land. The house is 85 per cent of the assessed value (136,000 divided by 160,000), so its basis is 85 per cent of the price, US$170,000. The land takes the other 15 per cent, US$30,000, and is never depreciated.

A home that was lived in before being let has its own starting point. The basis for depreciation is the lesser of two figures on the date of the change: the fair market value, or the owner's adjusted basis.

The basis then moves over time. Publication 527 lists what raises it, including additions and improvements. It also lists what lowers it, depreciation among them. On that last item the wording matters: the basis is reduced by depreciation "deducted or allowable". The reduction is not limited to amounts the owner remembered to claim.

When the owner also uses the home

Holiday homes and houses lent to relatives fall under rules of their own, set out in Topic no. 415. Everything turns on counting days.

A day of personal use is any day the unit is used by the owner or another person who has an interest in it; by a member of the family of either, unless that relative uses it as a main home and pays a fair rental price; by anyone under an arrangement that lets the owner use another dwelling unit; or by anyone at less than a fair rental price. The Schedule E instructions add one exclusion: a day the owner spends substantially full time repairing and maintaining the unit is not a personal day.

The owner is treated as using the unit as a residence when personal use in the tax year is more than the greater of 14 days, or 10 per cent of the days it is rented to others at a fair rental price. Two worked examples, with assumed day counts: a unit rented for 120 days at a fair price has a threshold of 14 days, since 10 per cent of 120 is only 12; a unit rented for 200 days has a threshold of 20 days.

The first row is the short-let exception. Topic no. 415 says that an owner who uses the unit as a residence and rents it for fewer than 15 days in the year does not report any of the rent and does not deduct any rental expenses.

Where there is both rental and personal use, expenses are divided according to the days of each. The Schedule E instructions give the example of 7 personal days and 63 rental days: about 10 per cent of the costs, 7 divided by 70, cannot go on Schedule E.

For a unit that is a residence, the deduction is also capped. Topic no. 415 says rental expenses cannot exceed the gross rental income once the rental part of mortgage interest, real estate taxes, casualty losses and direct rental costs such as realtors' fees and advertising has been taken off. Some of the excess may be carried to the next year, where the same limit applies again. The personal part of mortgage interest and property taxes may be claimed on Schedule A by an owner who itemises.

Passive losses and the US$25,000 allowance

Once depreciation is deducted, a rental can show a loss even when the rent covers the bills. Whether that loss reduces tax on a salary depends on the passive activity rules of Publication 925.

The publication classes rental activities as passive, even when the owner materially participates, unless the owner is a real estate professional. A passive loss is in general not allowed against other kinds of income. It is not lost: the disallowed amount is carried forward to the next tax year.

The main relief is the special allowance. An individual who actively participated in a rental real estate activity may deduct up to US$25,000 of loss from it against non-passive income such as wages. Active participation is, in the publication's words, "a less stringent standard" than material participation. It means taking part in management decisions, such as approving new tenants, deciding on rental terms and approving expenditures. The owner, together with a spouse, must hold at least 10 per cent of the value of the activity throughout the year, and a limited partner is generally not treated as actively participating.

Filing status changes the ceiling. For a married person filing separately who lived apart from the spouse all year, it is US$12,500. For a married person filing separately who lived with the spouse at any time in the year, there is no allowance.

The allowance then shrinks as income rises. Publication 925 reduces it by 50 per cent of the amount by which modified adjusted gross income exceeds US$100,000, and removes it at US$150,000 or more. For a married person filing separately the figures are US$50,000 and US$75,000. Modified adjusted gross income is adjusted gross income worked out without certain items, among them taxable social security benefits and any passive income or loss.

Publication 925 works one case through. A taxpayer earns a salary of US$120,000 in 2025 and has a loss of US$31,000 from rental real estate in which the taxpayer actively participated. Income is US$20,000 over the threshold; half of that is US$10,000; the allowance falls from US$25,000 to US$15,000. The taxpayer deducts US$15,000 for 2025 and carries US$16,000 into 2026.

The real estate professional and at-risk rules

Two further rules sit beside the allowance.

The first lifts the passive label altogether. Under Publication 925, a taxpayer qualifies as a real estate professional when more than half of the personal services performed in all trades or businesses during the year were in real property trades or businesses in which the taxpayer materially participated, and those services came to more than 750 hours. On a joint return, the publication adds, one spouse must meet both tests alone, without counting the other's services. For a taxpayer who qualifies, rental real estate in which the taxpayer materially participated is not passive.

The second comes first in the order of calculation. The at-risk rules limit a loss to the amount the taxpayer actually has at risk in the activity, and Publication 925 says they are applied before the passive activity rules. Form 6198 is the form used.

Reporting the year on Schedule E

The year's figures for a let house or flat go on Part I of Schedule E, which is filed with Form 1040, according to the 2025 instructions.

Depreciation needs a second form in some years. The instructions require Form 4562 to be attached when depreciation is claimed on property first placed in service during the year, on listed property, or when a section 179 deduction or amortisation begins that year. An owner with more than three properties attaches further copies of the schedule and fills in the totals, lines 23a to 26, on one of them only.

Form 8582, the passive loss form, is not always needed. The Schedule E instructions waive it when all of these are true:

1. Rental real estate activities are the taxpayer's only passive activities.
2. There are no unallowed passive losses from earlier years.
3. The taxpayer actively participated in all of the rental real estate activities.
4. A married person filing separately lived apart from the spouse all year.
5. The overall net loss is US$25,000 or less, or US$12,500 or less if married filing separately.
6. There are no current or earlier unallowed passive activity credits.
7. Modified adjusted gross income is US$100,000 or less, or US$50,000 or less if married filing separately.
8. No rental real estate interest is held as a limited partner or as a beneficiary of an estate or trust.

Not every letting belongs on Schedule E. The instructions send it to Schedule C when the owner provides significant services to the occupants, such as maid service; heat, light, trash collection and the cleaning of public areas do not count as significant.

Two other items are flagged by the IRS without being part of the schedule's sums. A rental profit may be subject to the net investment income tax, reported on Form 8960. And income on Schedule E may count as qualified business income; Topic no. 414 mentions a deduction of 20 per cent for owners who meet the safe harbour conditions of Revenue Procedure 2019-38.

At sale, the depreciation returns

Every dollar of depreciation lowers the adjusted basis, and the gain on a sale is measured from that lower figure. A worked example, with assumed figures: a house and land bought for US$200,000, with no later improvements; depreciation of US$60,000 over the years of letting; a sale that brings US$260,000 after selling costs. The adjusted basis is US$140,000, which is US$200,000 less US$60,000. The gain is US$120,000, which is US$260,000 less US$140,000, although the price rose by only US$60,000. Because Publication 527 reduces basis by depreciation deducted or allowable, the starting point is the same for an owner who never claimed it.

The rate on that gain is not uniform. In the Form 4797 instructions, section 1250 property is depreciable real property, and the form's ordinary-income recapture generally applies where an accelerated method was used. The instructions state that it does not apply to 27.5-year residential rental property placed in service after 1986, which is depreciated on a straight line. Topic no. 409 nonetheless sets a separate ceiling for this kind of property: unrecaptured section 1250 gain is taxed at a maximum rate of 25 per cent, above the rates that apply to most long-term gains.

Depreciation is a deduction with a second half. It lowers taxable rent each year and raises the taxable gain on the day of sale.

Those ordinary long-term rates, for tax years beginning in 2025, are given in Topic no. 409: 0 per cent for a single filer with taxable income up to US$48,350, or a couple filing jointly up to US$96,700; 15 per cent up to US$533,400 for a single filer, or US$600,050 for a joint return; 20 per cent above. Long-term means the property was held for more than one year.

The pages read for this guide state the 25 per cent ceiling but do not set out the worksheet, attached to Schedule D, that measures how much of a gain falls under it. The example above therefore stops at the total gain.

Several mechanics of the sale appear in the Form 4797 instructions. A gain on depreciable real property held for more than a year is entered in Part III of the form, and a loss in Part I. An exchange for other real property of a like kind goes on Form 8824. And where the property was also the owner's home, the instructions say the home sale exclusion cannot cover gain to the extent of depreciation for periods after 6 May 1997.

Under Publication 527, depreciation stops when a property is retired from service. What becomes of passive losses carried forward to that point is governed by Publication 925, in a part not covered here.

Kooky, from Shaka

Kooky edits Agents Estate and builds Shaka, the payment router he made for real estate professionals. One payment comes in, and every agent, agency and party in the deal receives their signed share on closing date.

About Kooky and Shaka →