Rental Property Income Tax: How Rental Income Is Taxed, Depreciation, and the Passive Activity Rules
Rental property income is reported on Schedule E (Form 1040), not Schedule C. It’s classified as passive income under IRC 469, which means it follows different rules than active business income. Rental income is NOT subject to self-employment tax (15.3%), but it IS subject to the Net Investment Income Tax (3.8%) for taxpayers with modified AGI above $200,000 (single) or $250,000 (MFJ). Depreciation is the most powerful tax benefit of rental property ownership: it creates a non-cash deduction that shelters rental income from current taxation.
How rental income is taxed:
- Gross rental income minus operating expenses (insurance, repairs, property management, property taxes, mortgage interest) minus depreciation = net rental income or loss.
- Net rental income is taxed at ordinary income tax rates (10-37%).
- Net rental losses are passive losses under IRC 469. They can offset other passive income (from other rental properties or passive business interests) but generally cannot offset W-2 or active business income.
- The $25,000 exception: Taxpayers who “actively participate” in rental activities (make management decisions, approve tenants, authorize repairs) can deduct up to $25,000 in rental losses against non-passive income. This exception phases out as modified AGI rises from $100,000 to $150,000 and is gone at $150,000.
- Real estate professional status: Taxpayers who spend more than 750 hours a year in real property trades or businesses AND more than half of all their working time in them, and who also materially participate in the rental, can treat rental income as non-passive. This lets rental losses offset W-2 and active business income, subject to the excess business loss cap.
How does depreciation work for rental property?
Residential rental property is depreciated over 27.5 years using the straight-line method under IRC 168. Only the building value is depreciated (land isn’t depreciable). The depreciation deduction is a non-cash expense that reduces taxable rental income without reducing cash flow.
What happens when you sell the rental property?
When the property is sold, the accumulated depreciation is “recaptured” and taxed at a maximum rate of 25% under IRC 1250. Any gain above the original purchase price is taxed at long-term capital gains rates (0%, 15%, or 20%).
After 10 years of $8,727/year depreciation, the accumulated depreciation is $87,270. If the property is sold for $350,000:
- Adjusted basis: $300,000 - $87,270 = $212,730
- Total gain: $350,000 - $212,730 = $137,270
- Depreciation recapture (taxed at 25%): $87,270 x 25% = $21,818
- Capital gain above original cost (taxed at 15%): $50,000 x 15% = $7,500
- Total tax on sale: $29,318
A IRC 1031 exchange into another investment property defers both the depreciation recapture and the capital gains tax.
What is the difference between Section 179 and bonus depreciation?
Both allow accelerated cost recovery, but they work differently. Section 179 lets you deduct the full cost of qualifying assets in the year placed in service, up to an annual limit ($1,220,000 in 2024), but only against net business income (it cannot create a loss). Bonus depreciation (60% in 2024, phasing down 20% per year) applies to both new and used property with no dollar limit and can create a net operating loss. Section 179 requires an active election on the return. Bonus depreciation applies automatically unless you elect out. For most small businesses, Section 179 is preferred when income supports the deduction. Bonus depreciation is better when you want to generate or increase a loss for carryforward.
What is bonus depreciation and how has it changed recently?
Bonus depreciation allows you to deduct a large percentage of an asset’s cost in the first year, rather than spreading it over the full MACRS recovery period. Under the Tax Cuts and Jobs Act, bonus depreciation was 100% for assets placed in service from September 27, 2017 through December 31, 2022. It began phasing down by 20% per year: 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% in 2027. Unlike Section 179, bonus depreciation can create or increase a net operating loss, which you can then carry forward to offset future income. Bonus depreciation applies to new and used property (the TCJA removed the new-only requirement), as long as you have not previously used the asset.
Related guides:
Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and tells you in writing what's wrong and how to fix it, three to four business days after you finish the questions. The report is $250. If you hire us for any work after that, you get the $250 back as a discount on that work. Or send us your return or your letter and get a fixed price, free.
One or two plain-English guides a week on US-Canada tax. No spam, unsubscribe anytime.
Done. The next guide will land in your inbox.
Yarik Yarosh, CPA. "Rental Property Income Tax: How Rental Income Is Taxed, Depreciation, and the Passive Activity Rules." Blue Cloud CPA, September 5, 2026, updated September 23, 2026. https://bluecloudcpa.com/guides/real-estate-investing-rental-income-taxes
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.