Rental properties are an investment type that fits into its own category. Many people favor rentals because of how tangible and immediate they are. Investing in real estate can create an additional perceived level of control compared to owning a stock. However, the trade-off is that rental properties require more oversight, recordkeeping, and ongoing management. When it comes to the tax consequences of rental properties, they can be very helpful as a piece of your larger tax planning strategies, but they can also make things much more complicated if you are not careful.
Key Takeaways
- The IRS treats rental property profits as taxable income, but views rental income as a passive activity. This often means the property’s tax treatment generally cannot be used to lower your overall taxes or affect other tax-planning areas.
- If there is income to deduct from, rental properties offer a range of deductions, including property taxes, insurance, repairs, and maintenance, among others.
- If you can prove to the IRS that you are actively managing the property, you can turn rental income from passive to active income. This would allow your rental income to offset your wages or other income.
- You can also work with your accountant to adjust your rental property depreciation schedule to optimize your taxes. You’ll need to consider when a sale will occur and what your capital gains and depreciation recapture might look like before doing this.
1. Rental Income is Taxable Income
At the most basic level, profits from a rental property are generally treated as taxable income. Net of deductions, the amount you take home from a given property will likely be treated as ordinary income. Importantly, though, the IRS generally views rental income as a passive activity, and not as earned or active income (more on this in a minute). In many cases, this means the property’s tax treatment is largely isolated and generally cannot be used to lower your overall taxes or affect other tax-planning areas.
2. Deductions are Popular
Many of the marketing ploys for rental properties revolve around the deductions associated with them. To be fair, there are many deductions worth taking advantage of, similar to a small business. Many of the expenses required to operate a property could potentially be deducted, including property taxes, insurance, repairs, and maintenance, among others. It is critical to keep good records, invoices, receipts, etc., to ensure your accountant can maximize your deductions. Deductions are helpful, but only if there is income to deduct from.
3. Passive Activity Rules Could Swing Things
It is possible to turn rental income from passive income into active income. The reason it would be advantageous to do so is that your income can now offset your wages or other income. For example, if you take a loss in the first year of the property due to some major deductions, those losses could offset your wages or other active income.
In order to do this, however, you need to prove to the IRS that you are actively participating in the property and in real estate more broadly. There are tests you must pass to get here, including spending more than half of your working hours in real estate and/or 750 total hours working in real estate. If you are not truly a real estate professional, the tests set a relatively high bar that may not be worth reaching.
4. Depreciation Can Be a Major Decision
One of the strongest tax planning levers to pull in real estate is the depreciation schedule for a given property. Most people deduct a residential rental property evenly over the standard 27.5 years, which at least provides a consistent deduction each year, apart from any improvements. However, it is possible to perform a Cost Segregation study and change the depreciation schedule. Instead of deducting the entire value evenly each year, you can pull some or most of the deductions into the first few years to increase your deductions today.
You are not necessarily saving taxes, just moving the depreciation from later years to earlier years. However, tax planning is not done in a vacuum. It could easily be the case that your tax rate is higher now than it will be in future years, so getting a larger deduction today and a smaller one in the future could literally save you thousands in taxes. Tax rates both now and in the future must be considered, especially since the sale of the rental property could likely be a larger taxable event.
5. Capital Gains and Depreciation Recapture
Thinking with the end in mind is important when buying rental properties. Specifically, because when the day comes to sell the property, there could be capital gains tax and depreciation recapture at the time of sale. Hopefully, rental properties are sold at a gain, since that would verify that the investment was successful. However, capital gains tax could apply to the difference between your cost basis and the sale price. If you bought it for $200,000 with no repairs and sold it for $300,000, the $100,000 could be subject to taxes. If a married couple has over $98,900 in income in 2026, their capital gains tax rate would likely be 15%.
Depreciation recapture is also important, especially if you accelerated depreciation through a Cost Segregation study. Depreciation lowers the cost of the property, but the IRS recoups it if you end up selling for a gain. So if you purchased a $200,000 property and depreciated $150,000 by the time it was sold, you could owe up to 25% depreciation recapture to get back to the $200,000 original basis. This is why it is important to factor in when a sale would occur before deciding how to depreciate the property.
6. 1031 Exchanges
Finally, there is one way to delay or defer a large potential tax bill on the sale day. Namely, by doing a 1031 Exchange. If certain rules are met, it is possible to sell a rental property and roll the proceeds into a new rental property without incurring a significant taxable event. It essentially acts as a swap of properties and can potentially bypass dealing with the capital gains or depreciation recapture at that time. While there are many regulations to follow to do these successfully, 1031 exchanges should give you more control over when you want to “get out of real estate” and not necessarily be tied to one individual property.
Taxing Properties
Real estate investors need to understand how these different tax considerations fit into any given investment. On top of determining whether a new property is a good investment, one needs to understand what the tax implications are of this investment. Knowing how rental income is taxed, how depreciation and deductions are factored in, and how the sale impacts the numbers is the key to a good rental property investment. Don’t let taxes get in the way of good investments, but recognize when rental properties are a good addition to your overall plan, and when you are just creating unnecessary headaches.
