How is rental income taxed? A guide for real estate investors

If you’re a real estate investor who has purchased one or more rental properties, you can benefit from relatively passive income flowing into your pocket. But as with other forms of income, you must pay taxes. That begs several questions: What counts as rental income? How is rental income taxed? What capital gains on rental property will you need to pay? And what are some common rental property tax deductions you can take advantage of?

Read on for answers and to learn more about rental income sources beyond monthly rent payments – including retained security deposits, lease cancellation payments, property or services received instead of rent, and partial interest – why it’s important to report rental income correctly, and how much you can expect to pay.

What counts as rental income?

Truth is, you’ll need to include more than your monthly rent check as you tally up your rental income. Here’s a closer look at some of the things that count as rental income for tax purposes:

• Regular rent payments: Of course, your tenant’s monthly rent check is considered rental income.
• Advance rent payments: If your tenant pays rent in advance, that’s considered rental income. Case in point: If your tenant puts down the first and last month’s rent before moving in, both rental payments are considered income when you receive those funds.
• Security deposits: If your tenant makes a security deposit, which you intend to return at the end of the lease, that’s not considered income. But if you retain some of the security deposit to cover damages, the portion you keep counts as income.
• Lease cancellation or termination payments: If a tenant has to pay a fee to cancel a lease, that fee counts as rental income.
• Property or services received instead of rent: When you receive property or services from your tenant in place of rent, the value of the rent payment must be counted as rental income. For example, if you waive your tenant’s monthly rent payment because they installed a fence, you would need to count that waived rent payment as income.
• Tenant-paid owner expenses: If the tenant covers expenses they aren’t responsible for, and deducts the expense from their rent, the covered expense must be reported as income. As an example, let’s say your tenant pays an appliance repair bill that wasn’t their responsibility under the lease. When they deduct this expense from their rent, you must count the bill amount as income.
• Partial interest: If you only own a portion of the rental property, you must report your share of the profits. For example, if you own 50% of a property, you must report 50% of the rental income on your tax return.
• Lease with option to buy: If your tenant has the option to buy the property, all payments received are considered rental income.

How taxes on rental income work

For tax purposes, the IRS treats rental income as regular income. This means you’ll need to add your rental income to any other income sources you may have when you file your taxes. Keep in mind that you may be able to deduct certain qualified expenses to decrease what you owe at the end of the year.

The ability to deduct qualified expenses is one of the many tax benefits that come with owning rental properties. But remember that, after all deductions are accounted for, your rental income is added to your regular income.

State taxes on rental income

States generally tax rental income as part of a taxpayer’s ordinary income – using the same rules that apply to other types of income earned within the state.

“If the rental property is located in a state, that state typically has the right to tax the income, even if the owner lives elsewhere, and the owner may need to file a non-resident state return,” says Scott Vance, a CFP and enrolled agent. “Most states start with federal taxable income and then make state-specific adjustments, such as different rules for depreciation or deductions.”

Also, some states have no personal income tax, in which case rental income may not be taxed at the state level, although local taxes or fees can still apply.

Taxes on short-term rental properties

The IRS treats primary residences and rental investment properties differently. For example, you can deduct many property expenses if it’s a rental, but not if it’s your home. But what if you rent out your home for part of the year?

First, know that income earned from short-term rentals, such as Airbnb or VRBO properties, is taxed the same as income from long-term rentals. Second, be aware that if you live at a property for more than the greater of 14 days or 10% of the total days you rent it to others (at a fair rental price), it’s considered a primary residence. Understanding the 14-day and 10% rule can help you avoid paying taxes on some short-term rental income.

Common rental property tax deductions

Generous tax deduction opportunities are among the things that make owning a rental property attractive. In general, the IRS allows you to deduct any ordinary and necessary expenses for managing and maintaining your rental property. Ordinary expenses include costs that most property owners face, while necessary expenses are unavoidable.

While there are many different types of rental property tax deductions, here are some of the most common.

Mortgage interest

Property owners are allowed to deduct mortgage interest paid. This includes interest paid on loans used to buy, improve, or refinance a rental property.

“This includes interest on refinanced debt to the extent it relates to the original purchase or improvements,” says Amit Maheshwari, an Illinois-based licensed tax professional and enrolled agent.

Property taxes

Property tax is an unavoidable expense for landlords. This cost can add up quickly, depending on the value and location of your property. The good news is that real estate investors can deduct property taxes on their investment properties.

As with all of these expenses, you’ll need to keep detailed records of your property tax payments.

Depreciation

Depreciation is a non-cash deduction that spreads the cost of a residential rental building (not the land itself) over 27.5 years. It can substantially reduce taxable income even when the property is cash-flow positive. You can calculate depreciation by dividing the purchase price minus the land value (the depreciable basis of the property) by 27.5 years.

“Property depreciation begins when the property is placed and serviced. It’s often a large tax benefit, but triggers depreciation recapture when you sell the property,” Maheshwari says.

Maintenance and repairs

As a property owner, you realize that upkeep on a residence can get expensive quickly. Fortunately, you can deduct these maintenance costs from your taxable income as a real estate investor.

Maintenance costs can include materials, supplies, and repairs to keep your rental property in good condition. For instance, you might deduct the cost of cleaning out the gutters or paying someone to cut the grass.

However, you cannot deduct the cost of improvements. If you’re making a major upgrade to the space, the costs of the improvement cannot be deducted.

Property management

If you pay for property management, you can also deduct this expense from your rental income. Most landlords can agree that property management is a necessary part of running a rental property. For property owners who aren’t able to commit to running the property by themselves, the cost of hiring help can add up quickly. Luckily, it’s a deductible expense.

Utilities

Do you pay for the utilities that your investment properties use? If so, you can deduct this necessary expense. Some landlords have their tenants pay for the utilities. But even they have gaps between tenants, which might require paying for utilities now and then.

Whenever you have utility costs tied to your rental property, you can deduct these expenses from your rental income.

Advertising

Every landlord wants to find the ideal tenants for their property. In many cases, this involves spending money on advertising when the property is available.

Cost-effective forms of advertising could include putting a “for rent” sign in the front yard. But if you want to reach a wide audience, you might need to post the listing on multiple platforms to draw in the perfect tenant.

All of these advertising opportunities come with a cost. As long as you track these expenses, the IRS allows you to write off advertising costs.

Insurance

If you don’t have a mortgage on the property, you might not be required to get landlord insurance. But having a sufficient amount of insurance coverage is strongly recommended. The only downside here is the cost of premiums.

As a real estate investor, you can deduct these sometimes-expensive premium payments from your rental income.

Homeowners association fees

If the property you own is within the jurisdiction of a homeowners association (HOA) or condominium, you’ll likely be forced to pay an HOA or condo fee. Depending on the situation, this fee could eat away at a significant portion of your profits.

Thankfully, as an investor, you can deduct the HOA fee or condo fee from your rental income.

Travel

If you travel to and from the property, you have an opportunity to deduct your travel expenses. While the deduction might not be very large if you live in town, it’s always worthwhile to write off any deductions you qualify for.

Start by tracking your mileage when traveling to your properties. The IRS allows you to write off a standard mileage rate, which is 70 cents per mile in 2025.

For investors who live farther away from their properties, travel expenses could add up faster. After all, flying to and from rental properties will likely involve a significant expense.

Be careful, however, about mixing business with pleasure. If you make a business trip to your property but spend double the number of days visiting family, then you might not be able to deduct the costs of this trip. Always ask a tax professional when you have questions about potential deductions.

Legal and professional services

Most real estate investors build a network of professionals to help them manage their rental property business effectively. For example, you might hire a lawyer or CPA along the way. In fact, working with these professionals can help you save time and hassle in the long run. And the fees for working with these experts can be tax-deductible, too.

Tax implications of selling a rental property

When you sell a rental property, you may be subject to various federal, state, and local taxes. Let’s take a closer look at each of these tax categories.

Capital gains tax and brackets

Capital gains taxes are imposed on any profit made from selling an asset, including rental property.

If the property is held for 1 year or less, capital gains are classified as short-term and taxed as ordinary income. If the property is held for over a year, capital gains are considered long-term and are taxed based on your overall taxable income.

Depreciation recapture

Ultimately, depreciation can lower your taxable income for the year. But keep in mind that the IRS will use what’s called “depreciation recapture” when you sell the property.

Depreciation recapture refers to when the IRS taxes the amount of depreciation you've deducted over the years if you were to sell the property. In other words, you’ll be required to pay back some of those tax savings.

If you want to pursue this deduction, it’s a good idea to consult a tax professional.

1031 exchange

In some cases, you can defer capital gains taxes by conducting a 1031 exchange. This involves using the proceeds from a property sale to buy another “like-kind” property. In fact, you can theoretically conduct back-to-back 1031 exchanges to defer capital gains taxes indefinitely.

However, there are limits. For example, from the time you sell your property, you must designate a replacement property within 45 days and close on it within 180 days. Consult a tax professional to learn more.

How to report your rental property income on your taxes

To ensure accurate reporting of your rental property income on your taxes, follow these recommended steps:

1. Maintain accurate tax records throughout the year. “Collect all records showing rental income received during the year, including rent payments, advance rent, retained security deposits, and any tenant-paid expenses,” suggests Vance. “Also, gather documentation for deductible expenses such as mortgage interest statements, property tax bills, insurance invoices, repair receipts, management fees, utilities, and travel logs.”
2. Determine your filing status. Decide whether you’ll file as single, married filing jointly, married filing separately, or head of household – which can impact your tax rates, deductions, and how your rental earnings and expenses are reported on your tax return.
3. Report your income on Schedule E. “Add up all your total rental income received during the year, regardless of when it was earned, and report this gross rental income – before expenses – on Schedule E, Part I, for each rental property you own,” Vance adds.
4. Deduct your expenses on Schedule E. List each deductible expense in the appropriate category on Schedule E, including advertising, insurance, utilities, repairs, taxes, management fees, and interest. However, only expenses that are ordinary, necessary, and related to the rental activity should be included here.
5. Report your depreciation on Form 4562. Calculate the depreciable basis of your property by subtracting the value of the land from the purchase price and adding qualifying improvements. “Residential rental property is typically depreciated over 27.5 years, and the annual depreciation amount is reported on Schedule E, with supporting details often calculated on Form 4562,” says Vance.
6. Carry over the totals to Form 1040. After subtracting total expenses and depreciation from your rental income, Schedule E will calculate your net profit or loss for each property. This amount flows to Schedule 1 and then to Form 1040 as part of your total income.
7. Apply passive activity loss rules (if applicable). “If your rental shows a loss, special rules can limit how much you can deduct in the current year,” Vance continues. “Losses may be limited by passive activity rules, income thresholds, or real estate professional status, with disallowed losses carried forward to future years.”
8. Report state and local rental income. If required, report rental income on your state tax return, particularly if the property is situated in a different state from where you live. Non-resident state filings may be needed, depending on your property’s location.
9. File and retain records. File your state and federal returns by the tax deadline, and retain all rental-related records for a minimum of 3 to 7 years, as basis and depreciation records may be needed when you sell the property.

The bottom line: Rental income is taxable, but deductions can help you lower your tax bill

One of the greatest perks of being a real estate investor is that you can tap into a wide range of real estate deductions. But, like everyone else, you still have to pay taxes on your rental income. Keep detailed records of your rental earnings and expenses to create a smooth tax filing experience. And take the time to consult with a trusted financial advisor and tax professional when it comes to your hard-earned money.

Interested in growing your real estate investment portfolio? Apply for a mortgage with Rocket Mortgage today.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.

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