One form of revenue that affects your tax return is rental property ownership. In order to help you optimize the tax benefits and develop a plan to reduce or postpone some of your taxes, let’s take a closer look at the Internal Revenue Service (IRS) tax regulations for owners of rental properties.

Depreciation deduction for rental properties and depreciation recapture

One recurring premise in “get rich quick” real estate books is that owning rental property can result in tax savings. The secret is the depreciation deduction, which is an annual tax benefit for a portion of your cost basis in rental properties. You can use this beneficial tax offset to reduce the taxable net income that your rental property generates. The fair market value of the land is not included in the value that the IRS allows you to decline over a 27.5-year period.

There are a few disclaimers though. For example, all those depreciation deductions have diminished your basis in your property if you sell your rental. When you sell, the difference between your selling price and your adjusted basis is your profit. In essence, you benefit from depreciation deductions on your taxes while you hold the property, but when you sell, you usually have to pay taxes on both the gain you would have received and the amount of depreciation deductions you claimed. This is known as depreciation recapture, and it is subject to a maximum 25% tax at your regular income tax rate. After then, the capital gains tax rates apply to your remaining profits.

However, don’t let this scare you off; it’s not all bad if depreciation deductions shift some of your tax liability to later years. Your money might work harder for you the longer you keep it. Alternatively, you might make the property the main residence for two years prior to selling it, which would prevent depreciation recovery. If you sell the rental property during a year when your income is lower or when you are selling other assets at a loss, you may also be able to lessen the tax burden.

Beware the passive activity and at-risk rules of investment property

Rental revenue is typically regarded by the IRS as a passive activity that is governed by particular regulations.

Let’s take an example where you experienced a net rental activity loss, which is quite probable due to the depreciation reduction. You are not able to deduct that loss from other taxable income, including your pay, under the rules governing passive activities. It is limited to offsetting passive income.

However, you might be eligible for a special discount if you—or, if you’re married, your spouse—participate actively in your rental real estate business. You may be eligible to deduct up to $25,000 in loss from the activity, subject to income limitations ($12,500 if you file as married filing separately and you lived apart from your spouse for the whole year). This loss can be deducted from nonpassive income, such your regular wage

You might be eligible to classify your real estate rental activity as a nonpassive activity if you are a real estate professional and you satisfy specific conditions for the amount of time spent on rental activities.

You cannot claim a tax loss greater than the amount you have at risk if your investment is not “at risk,” which means you cannot lose all or part of the money you have invested in it. Nevertheless, unless you are a real estate investor with a more complicated financial venture, you usually don’t need to worry about this guideline. The majority of part-time real estate investing falls under the category of “at risk.”

High adjusted gross income can mean no rental property loss deduction

Your maximum permitted loss is lowered if your modified adjusted gross income (MAGI) is between $100,000 and $150,000 or more ($50,000 and $75,000 if married filing separately). If your married filing separately income is $75,000, you are not eligible for a special allowance for a rental real estate loss if your MAGI is more than $15,000. Any loss that is not used up can be carried forward until a year in which your MAGI is lower, or until the year in which you sell the property or otherwise dispose of it.

Depreciation isn’t the only write-off you can take

Owners of rental properties can deduct more than just depreciation. Here are some more instances of deductible costs for rental properties:

• Advertising
• Auto expenses, either the standard rate of 0.67 cents per mile in 2024 (up from 0.655 cents in 2023) or your actual expenses, such as gas, oil, and depreciation
• Cleaning
• Mortgage interest (generally reported to you on Form 1098)
• Non-mortgage interest, such as credit card interest on a card you use only for rental expenses
• Insurance, including fire, flood, liability, and mortgage insurance
• Legal fees and tax preparation fees related to your rental activity
• Maintenance
• Property management fees
• Property taxes
• Property and liability insurance
• Repairs, such as repairing the dishwasher, regular repainting, or fixing a roof leak (just make sure the repairs you claim aren’t actually capital improvements, which instead become part of your basis)
• Supplies
• Travel expenses when you travel overnight to improve property
• Utilities

When to report income

Keep in mind that you declare income as soon as it is received if, like the majority of individual taxpayers, you operate on a cash basis. Regardless of the time frame for which the rent is applicable, this is true.

For instance, you must include the rental income in your 2023 taxes if your tenant pays you on December 30, 2023, for the rent due in January 2024. It is not helpful to wait until 2024 to cash the check; you have to disclose the income as soon as the funds are available to you.

Follow special rules for security deposits

Do not report a security deposit you receive as income if you intend to return it to the tenant. On the other hand, you have to record a nonrefundable deposit as income as soon as you get it.