Understanding Tax Implications For Rental Investors

Investing in rental property is one of the smartest ways to generate passive income and build long-term wealth. However, as an investor, you should expect different tax obligations than ordinary people. It is important to get your taxes right to maximize profits and avoid potential pitfalls.

  • The rental income from the investment properties is taxable income
  • Deduction on a variety  of expenses related to the investment property
  • Passive loss limitation of rental investors
  • Profit  is subject to capital gain tax
  • Depreciation is a tax benefit for investors
  • Difference between material participation and active participation

Investing in rental properties can be a profitable way to build wealth over time. Investors must be mindful of complex tax laws to optimize their returns and be compliant while making an investment[AA5] . This article will explore the importance of tax considerations for rental investors.

Rental Income Is Taxable

The rental income you receive from your investment property is considered taxable income by the Internal Revenue Service (IRS). This means that you will need to report your rental income on your annual tax return and pay taxes on it. The good news is that you can deduct certain expenses related to your rental property from your taxable income, which can reduce your tax bill significantly. Although you can expect favorable deduction treatment, it is essential that you are aware of your tax commitments during ownership so that you can strategize efficiently when you eventually sell it.

Deductible Rental Expenses

Asa rental investor, you can deduct a variety of expenses related to your investment property. Some common deductible expenses for rental investors include:

  1. Property taxes: You can deduct the property taxes paid on your rental property.
  2. Mortgage interest: If you have a mortgage on your rental property, you can deduct the interest paid on the loan. Your entire mortgage payment is not deductible.
  3. Repairs and maintenance: You can deduct expenses related to repairs and maintenance on your rental property, such as fixing a leaky roof or repairing a broken appliance.
  4. Insurance: You can deduct the cost of insurance premiums for your rental property.
  5. Depreciation: You can deduct the cost of the property over time. This can include the cost of the building and certain improvements that add value to the property. What is even more exciting is that you can perform a cost segregation on your property to further accelerate your depreciation.

Here is the list of some of the items:

  • Payment to kids if they maintain your property. 
  • Mileage: Keep track of any mileage related to the rental activity using apps like MileIQ. If you attend the same meeting each month, you can track the details for one month and use that information to estimate expenses for the rest of the year, assuming nothing has changed.
  • If you prefer not to use mileage, you have the option to deduct the actual expenses related to your car. This includes oil changes, maintenance, gas, repairs, parking, tolls, and depreciation. If you use a personal car, it is important to maintain a detailed record so that the CPA can allocate the expenses proportionately between personal and business use. These expenses also encompass oil changes, maintenance, gas, repairs, parking, tolls, and depreciation. Alternatively, you can choose to take a mileage deduction instead of calculating the actual costs.
  • Travel cost if your property is in another state. 
  • Meals when traveling away from home - 50% (100% in 2021) is deductible unless the meal is provided to the public (like Open houses) then it is 100% deductible. Open House expenses can include meals and entertainment (Balloons).
  • Expenses incurred while meeting with investors.
  • Expenses incurred while meeting with realtors.
  • Going to investors' meetings. Mileage and meals
  • Money paid for RE tax books is also a tax deduction.
  • Marketing expense and advertising.
  • Cleaning and maintenance.
  • Commission (Expenses like commission, abstract fees, and recording fees to obtain your mortgage are not deductible but rather capitalized)
  • Legal and other professional fees (Tax preparation for your business part, not the personal part)
  • Point/loan cost when your refi- you cannot deduct the full amount the first year but must deduct it over the term of the loan.
  • Repairs(Note always do repairs rather than improvements to rental because repairs are deductible right away and do not have to depreciate over many years as done for improvements. Repairs do not have to be recaptured (unlike depreciation) when you sell the house as well.)
  • Utilities- Pest control and such
  • Pre-rental expenses (expenses incurred before finding a tenant)- Startup cost. 
  • Any equipment you rent for the rental business.
  • Home office: Also, if your home qualifies for a principal place of business for RE activity, any mileage to any rental property is deductible.
  • Education- You must be careful of the education that you do before you buy the property, it might not be deductible.

It is important for rental investors to keep accurate records of their expenses throughout the year to take advantage of these deductions. They should also consult with a tax professional and experts to ensure that they are claiming all the deductions they are entitled to.

Capital Gains

Whenever a rental property is sold, any profit that is made is subject to capital gains tax. Capital gains tax is calculated based on the difference between the sale price of the property and its original purchase price. However, rental investor scan skip paying capital gains tax on the sale of one rental property and buy another one instead by using a 1031 exchange facility. The investor must follow specific rules and timelines to qualify for a 1031 exchange.


Depreciation is a key tax benefit for rental investors. However, it is important to understand that when you sell your rental property, you may be subject to depreciation recapture. Depreciation recapture is the process of paying taxes on the depreciation that you have claimed on your rental property over the years.

When you sell your rental property, you will need to recapture any depreciation that you have claimed by paying taxes on it. The recaptured depreciation is taxed at a rate of 25%. This can be a significant tax liability, so it is important to factor it into your calculations when deciding whether to sell your rental property. As iterated in the image below, when property is sold at a gain and accelerated depreciation has been claimed, one may have to pay the tax at an ordinary  rate to the extent that a portion of accelerated depreciation has been taken.

Passive Losses And Rental Income

One potential pitfall for rental investors is the passive loss limitation. If your rental expenses exceed your rental income, you may be able to deduct the resulting loss from your other income, such as wages or self-employment income. However, there are limits to how much you can deduct.

The IRS considers rental income to be passive income, which means that losses from rental activities can only be used to offset passive income. If you have more passive losses than passive income, you may not be able to deduct the entire loss in the current tax year. Instead, you may need to carry the excess loss forward to future tax years. With the help of an experienced CPA, you can figure out ways to tackle this complex rule to work in your favor.

There are two ways you can get around the passive activity loss limitation rules.

  1. Qualify as a real estate professional. See below.
  2. Deduct 25,000 losses under active participation rules. See below.
Real Estate Professionals

According to internal revenue services (IRS), a person who spends more than half of their working hours in the rental business is called a real estate professional. This may include property development, acquisition, construction, and management. To be qualified as a professional, you must be able to devote more than 750 hours per year to working on your real estate business. If you are not working full-time in real estate, you must meet another test that says you must work in real estate as much as you do in other jobs/businesses. These rules are complicated so please talk to your professional.

Real estate professionals’ activities are not viewed as a passive activity but instead the generated income is characterized as an active income. Also, you can use losses to offset other income and manage to avoid a 3.8% net investment tax if the rental generates income.


Active participation is classified as a lower standard of participation than material participation. To be recognized as actively participating by the IRS, you must make management decisions in a significant and bona fide sense. There are rules that count management decisions as active participation, which are as follows:

  1. Approving new tenants
  2. Determining rental terms
  3. Approving expenditures

Passive activity losses (PALs)can usually only be deducted in the following situations: (1) against income from passive activities, (2) when the entire interest in a passive activity is sold in a taxable transaction, or (3) through the $25,000 rental loss privilege for qualified rental activities (with the possibility of phase-out for individuals with an adjusted gross income (AGI) exceeding $100,000).

The general rule allows individuals to deduct rental real estate losses of up to $25,000against nonpassive income, provided they actively participate in the property. To qualify, the taxpayer must make management decisions, hold at least a 10%ownership share (excluding limited partners), and consider their spouse's ownership interest when calculating the minimum ownership requirement.

To be considered actively participating, one must make significant and genuine management decisions. Examples of such decisions include approving new tenants, setting rental terms, authorizing capital or repair expenses, and similar choices.

It is important to note that there is a phase-out if the taxpayer's MAGI (Modified Adjusted Gross Income) exceed $100,000.

If you can actively participate by making the management decisions listed above and have at least a 10% interest in the investment, you will be able to deduct some of your passive losses.


Understanding the tax rules for rental investments is important for making the most money and avoiding mistakes. You can lower your tax bill by deducting expenses, but there are limits to what you can deduct. It is also important to accurately understand depreciation recapture and the passive loss limitation rules. To make sure you are following the rules correctly, it is a clever idea to talk toa tax expert and seek advice from professionals.

Investor Friendly CPA® can assist you in the planning of all your taxes according to your requirements. Our experienced team can guide you to efficient planning which can help you lower your tax bills and increase your profit margins. We can also help you to understand taxation and discuss what can be beneficial for you.