How Rental Property Is Taxed: Depreciation, Losses, and the Bill at Sale

A rental property that puts $3,807 into your bank account can, entirely legitimately, report a $1,679.73 loss on your tax return. Both numbers describe the same property in the same year. Neither is a trick.

That gap is where most confusion about rental taxation lives, and it produces two opposite and equally expensive mistakes. Some owners see the loss and conclude their accountant erred, or that the property is failing. Others never claim the deduction that creates it, and pay tax every year on income they did not have to report — and then pay again at sale, because the tax code assumes they claimed it whether they did or not.

This article is about the mechanism: why the two sets of books disagree, whether a loss on paper is a loss you can actually use, and what has been quietly accruing since the day you bought.

A note before you start. This is general tax education about federal law only, not tax advice, and it is not a substitute for a CPA. Every state that taxes income taxes rental income too, on its own rules, and none of that is covered here. Statutory citations link to the primary text so you can check them. The worked example uses illustrative inputs stated on the page. Tax law changes — at least one provision discussed here changed in July 2025 — so verify anything you intend to rely on, and take your own situation to a qualified professional.

1. The two sets of books

Here is the property, and it is the same one used across this site's other investment articles: bought for $265,000, with $3,400 of closing costs added to basis, financed with $198,750 at 7.125% over 30 years, several years into ownership.

The cash books:

The tax books, same year, same property:

Two differences produce the entire gap, and they run in opposite directions.

Principal is not an expense. The $2,130 of principal left your account but bought you equity — it converted cash into ownership. It is not deductible, and entering the whole mortgage payment on the interest line is the single most common error on a self-prepared Schedule E. Your lender's Form 1098 gives you the interest figure, and that is the only deductible part.

Depreciation is an expense you did not pay. The $7,616.73 never left your account. It is the code's recognition that the building wears out, spread across 27.5 years, and it is deductible whether or not the property actually declined in value — which, in most years, it did not.

2. Depreciation: the three parameters

Residential rental property depreciates on rules that are almost entirely fixed.

27.5 years, set by IRC § 168(c)'s table for residential rental property.

Straight line, required by § 168(b)(3)(B). The same deduction every year: depreciable basis ÷ 27.5.

Mid-month convention, under § 168(d)(2). Whatever day you place the property in service, the law treats it as mid-month. This affects the first year and the year of disposal only. The first-year fraction is (12 − month + 0.5) ÷ 12, so a June placement gets 6.5/12.

One definitional point: § 168(e)(2)(A)(i) defines residential rental property as a building from which 80% or more of gross rental income comes from dwelling units. A mixed-use building below that threshold is nonresidential and depreciates over 39 years instead.

The land split, which sets everything

Land is not depreciable. IRS Publication 527 is direct about it: you cannot depreciate the cost of land, because land generally does not wear out, become obsolete, or get used up.

So basis has to be split, and that split — made once, usually in about four seconds — determines every deduction for 27.5 years.

On a $268,400 basis:

The gap between 22% and 35% is $1,268.80 every year — $34,892 across the full schedule.

The most defensible method is your county assessor's own ratio, applied to your actual basis. The assessment splits the property into land and improvements, it is public record, you did not create it, and the tax bill documents it. Use the ratio, not the assessor's dollar values, which usually sit below market.

On the worked property: assessor values land at $56,000 against $255,000 total, a 21.96% ratio. Applied to $268,400 that is $58,940 of land, leaving $209,460 depreciable and $7,616.73 a year.

3. The sentence that costs people the most money

There is one phrase in the depreciation rules worth more than everything else in this article: your basis is reduced by depreciation allowed or allowable.

Not "allowed." Not "claimed." Allowed or allowable — the amount you were entitled to deduct, whether or not you actually deducted it.

Suppose you own the property for ten years and never claim depreciation. At sale, the IRS calculates your gain using a basis reduced by the $76,167 you were allowed to take. You pay tax on that gain at up to 25%, exactly as if you had claimed it. But you never got the deductions.

You paid the price and received nothing.

There is no version where not claiming wins. It is not an aggressive position or a matter of preference — it is the only rational choice, and the only question is whether you take the deductions on the way through or eat the recapture at the end for free. If you have already missed years, the fix is a change in accounting method rather than amending old returns, and it is routine work for a CPA.

4. Repair or improvement: when you deduct, not whether

Every dollar spent on the property is either deducted this year or capitalised and recovered over 27.5 years. The same $8,000 is worth $8,000 now or roughly $291 a year for nearly three decades.

The test asks whether the work is a betterment, a restoration, or an adaptation to a new use. The shorthand — does it improve the property or just keep it working — is a decent first filter.

The pattern: the same activity flips depending on scope. One window is a repair; all the windows is not. Work done as part of a general plan of rehabilitation is capitalised even where individual items would have been repairs alone — which is why the renovation between purchase and first rental is nearly always capitalised in full.

The de minimis safe harbor lets you expense items costing up to $2,500 per invoice rather than capitalising them, with an election attached to a timely return. One detail matters here: the regulation this lives in still literally reads $500. The $2,500 comes from IRS Notice 2015-82, effective for years beginning on or after 1 January 2016. Anyone citing the regulation alone gives you a number wrong by a factor of five. It has not moved since 2016 and is not indexed.

5. Whether you can actually use a loss

A loss on Schedule E is not automatically a loss you can deduct against your salary.

Rental activity is passive by default under IRC § 469, essentially regardless of how much time you spend on it, and passive losses generally offset only passive income. Your salary is not passive income. Neither are your dividends.

The $25,000 exception

§ 469(i) allows up to $25,000 of rental loss against ordinary income if you actively participate — a genuinely low bar, much lower than material participation. Approving tenants, approving repairs, and setting rents all count, and using a management company does not disqualify you provided you keep decision authority.

It phases out at fifty cents per dollar of modified AGI above $100,000, and disappears at $150,000.

The arithmetic: $25,000 − 0.5 × (MAGI − $100,000), floored at zero.

And here is the fact that reframes the whole provision: the $25,000 has been $25,000 since 1986, and neither it nor the thresholds are indexed for inflation. There is no adjustment provision anywhere in § 469. A threshold set at $100,000 in 1986 now reaches households nowhere near where it was aimed, and the allowance is worth a fraction of its original value in real terms.

Suspended does not mean lost

A loss you cannot use carries forward indefinitely and releases in three ways:

1. Against passive income in a future year, including from this property in a profitable one
2. Against passive income from any other passive activity you own
3. In full, when you dispose of the property in a fully taxable transaction to an unrelated party

That third is the significant one. A landlord carrying $40,000 of suspended losses into a sale releases all $40,000 against the gain — a substantial offset arriving in exactly the year it is needed. It only works if someone tracked the number, and it is the figure most commonly lost when changing accountants.

Note the conditions: fully taxable, to an unrelated party. A 1031 exchange is neither, which is one of the real trade-offs of exchanging rather than selling.

The route out, and why it is narrow

Above $150,000 the allowance is gone and every loss suspends. The exception is real estate professional status, and § 469(c)(7)(B) requires both tests:

1. More than one-half of your personal services in trades or businesses are in real property trades in which you materially participate, and
2. More than 750 hours of services in those trades

The conjunction is "and." The first test is what defeats most people who try: a 2,000-hour job outside real estate means you would need more than 2,000 hours in real property trades — a second full-time career. For a full-time employee in another field, this status is effectively unavailable.

It is also the most litigated provision in this area, and the cases turn overwhelmingly on whether a contemporaneous time log exists. Reconstructions after an audit begins are routinely rejected.

6. The bill at sale

Depreciation is a deferral, and this is where it comes due. Three charges apply at different rates.

Unrecaptured section 1250 gain — the portion of gain attributable to depreciation taken or allowable. Taxed at a maximum of 25% under IRC § 1(h)(1)(E). It is a maximum, not a flat rate: the actual rate is the lesser of 25% or your ordinary rate.

Long-term capital gain — the remainder, the appreciation above your original basis, at long-term rates if held over a year.

Section 1245 recapture as ordinary income — for personal property components like appliances depreciated on shorter schedules. Usually small on a single-family rental.

Worked, on our property held ten years and sold for $340,000 with $27,200 of selling costs:

Splitting it:

The capital gains rate is illustrative — the actual rate depends on total income and the brackets change annually. What is not illustrative is the structure: the depreciation portion is the larger half of the gain, and it is taxed at a higher rate than the appreciation. On a long hold, recapture dominates the bill.

There is one further charge this article deliberately does not quantify: the 3.8% net investment income tax under § 1411 can apply to gain on a rental sale above certain income thresholds. It is real and commonly overlooked — raise it with your CPA rather than taking a number from anywhere without a citation.

7. The two escape routes, in outline

Section 1031 exchange. Defers the entire gain, recapture included, by rolling it into a replacement property. Real property only since 2018. Forty-five days to identify a replacement, and receipt by the earlier of 180 days or your return's due date including extensions — that second limb is omitted by a lot of sources and it shortens exchanges started late in the year. A qualified intermediary is mandatory; touching the proceeds yourself disqualifies the exchange.

Section 121 exclusion. Excludes up to $250,000 of gain ($500,000 married filing jointly) on a principal residence, if you owned and used it as such for two of the five years before sale. Both figures have been fixed since 1997 and neither is indexed. Where it touches rentals is the conversion case — and there is an asymmetry almost nobody knows: renting a property after you stop living in it generally does not count against the exclusion, while renting it before you move in generally does. In every case, gain attributable to depreciation taken after 6 May 1997 is never excludable.

Both routes have real conditions and real trade-offs, and both are worth planning before you list rather than discovering afterwards.

Frequently asked questions

My rental shows a loss. Did I do something wrong? Almost certainly not. Depreciation is a non-cash deduction of roughly a twenty-seventh of the building's value each year, and it routinely turns a cash-positive property into a paper loss. That is the intended operation of the rules. Whether you can use the loss is a separate question the § 469(i) allowance answers.

Why can't I deduct my whole mortgage payment? Because most of it is not an expense. Interest is a cost of borrowing and is deductible; principal converts cash into equity, which is the purchase of an asset. Depreciation is already the mechanism for recovering that cost, so deducting principal too would deduct the building twice.

Can I skip depreciation to avoid recapture later? No, and trying costs you twice. Basis is reduced by depreciation allowed or allowable — what you were entitled to claim, regardless of whether you claimed it. You lose the deduction now and pay the recapture anyway.

How do I split the price between land and building? The most defensible method is your county assessor's ratio applied to your actual basis. It is public record, you did not create it, and the tax bill documents it. Use the ratio, not the assessor's dollar figures, which usually sit below market.

I read the de minimis safe harbor is $500. The regulation does say $500 — and it also says "or other amount as identified in published guidance." Notice 2015-82 raised it to $2,500 for taxpayers without an applicable financial statement. Both are true; $2,500 is the operative figure.

My income is over $150,000. Is the loss gone? Suspended, not gone. It carries forward indefinitely, releases against future passive income, and releases in full on a fully taxable sale to an unrelated party. Track the running total — it is worth real money at exit.

Do I qualify as a real estate professional? Only if you meet both tests in § 469(c)(7)(B): more than half your personal services in real property trades where you materially participate, and more than 750 hours. If you work full time in another field, the first test is generally out of reach.

What is the single most useful thing to get right? Claim the depreciation, and set the land split defensibly at the start. Those two decisions compound over 27.5 years and neither is easy to fix later.

What to do next

The arithmetic in this article is the mechanism. Applying it to your own property is a separate exercise, and the rental analysis calculator is deliberately the wrong tool for it — it measures the property as an operating business and excludes tax effects entirely, for the same reason this article excludes cap rate.

• Hold-period return calculator — cash flow, principal paydown, and the sale, also deliberately before tax
• Investment cash-to-close — the basis-relevant costs on the way in
• Cap rate, cash-on-cash, and DSCR explained — the other set of books
• The five expenses that make a rental look better than it is — before the tax question, the deal question
• How our figures are sourced

This article is general tax education about federal law, not tax, legal, or financial advice, and no reader-specific relationship is created by it. State income tax treatment of rental income is not covered and differs materially by state. Statutory citations link to primary text; tax law changes, and at least one provision discussed here changed in July 2025. Worked figures are arithmetic on illustrative inputs, not predictions about any real property. Consult a qualified tax professional about your own situation before filing, and before selling.