Tax Implications of Renting Out Your Primary Residence

The tax implications of renting out your primary residence start the day a tenant moves in: the rent you collect becomes taxable income reported on Schedule E, you gain deductions for operating costs and a mandatory annual depreciation write-off, your ability to claim a net loss against wages is capped, and when you eventually sell, part of the gain tied to depreciation is taxed even if the home-sale exclusion still covers the rest.

What You Have to Report as Rental Income

Every payment you receive for the use of the property is rental income, reported on Schedule E of your Form 1040.¹ That includes advance rent, which is taxable in the year you receive it rather than the year it covers.²

Security deposits sit outside that rule if you intend to return them at lease end. The moment you keep any portion because of damage or a broken lease, that amount becomes income in that year. And a deposit labeled as “security” but actually earmarked as the tenant’s last month’s rent is treated as advance rent, taxable on receipt.³

What You Can Deduct

Once the property is a rental, the ordinary costs of running it become deductible. Publication 527 lists the common categories: mortgage interest, property taxes, insurance, advertising, utilities paid on the tenant’s behalf, management fees, legal and professional fees, cleaning, and local transportation tied to the rental.²

Repairs and improvements are treated differently. A repair keeps the property in working order without adding value or extending its life. Fixing a leaky faucet, patching drywall, replacing a broken window. These are fully deductible in the year you pay. An improvement adds value, adapts the property to a new use, or meaningfully extends its useful life. A new roof, a kitchen remodel, a new deck. Improvements cannot be written off at once. You depreciate them over time. The IRS’s Tangible Property Regulations govern where the line falls.⁴

Depreciation Is Not Optional

Depreciation is the largest tax benefit of a rental and the one most people misunderstand. It lets you deduct part of the building’s cost each year for wear and tear, even while market value is climbing. Residential rental property is depreciated over 27.5 years on a straight-line basis under the Modified Accelerated Cost Recovery System, reported annually on Form 4562.⁵

The starting basis at conversion is not simply what you paid. It is the lesser of the property’s fair market value on the conversion date or your adjusted basis at that time. Adjusted basis is generally the original purchase price plus capital improvements made during personal use.² The rule blocks you from depreciating a decline in value that happened while you lived there. If you bought for $400,000, added $50,000 in improvements, and the home was worth $380,000 at conversion, your depreciable figure is $380,000, not $450,000.

Only the building depreciates. Land never does, so you allocate value between structure and lot. The common approach borrows the split from your county property tax assessment: if the assessor puts land at 20% of total value, 20% goes to land and the remaining 80% is depreciated.

Here is the trap. Depreciation is not optional. Skip it and the IRS still reduces your basis at sale by the amount you should have claimed. The statute reduces basis by depreciation “allowed or allowable,” whichever is greater.⁶ Skipping the annual deduction does not spare you the tax bill later. It just costs you the deduction.

Can You Deduct a Loss Against Your Salary?

Rental real estate is a passive activity by default, and passive losses cannot freely offset wages or other active income. If depreciation plus expenses exceed rent, that net loss is limited.

The main relief is the active participation allowance. If you make management decisions on the property — approving tenants, setting rent, authorizing repairs — and own at least 10%, you can deduct up to $25,000 of rental losses against non-rental income each year.⁷ You do not have to swing the hammer yourself.

The $25,000 shrinks as income rises. It phases out by $1 for every $2 your adjusted gross income exceeds $100,000 and disappears entirely at $150,000 AGI.⁷ At $130,000 AGI, for example, you are $30,000 over the threshold, half of that ($15,000) comes off the allowance, and you are left with $10,000 of deductible loss. Anything above that carries forward to offset future rental income or to be fully released when you sell.

A separate exception for real estate professionals treats rental losses as non-passive, but it requires more than 750 hours of service in real property businesses during the year and more than half of your total personal services in those businesses.⁸ Someone with a full-time job outside real estate will not qualify.

The 3.8% Surtax on Rental Profits

Net rental income is subject to an additional 3.8% Net Investment Income Tax if your modified AGI exceeds $200,000 single or $250,000 married filing jointly. The tax applies to the lesser of net investment income or the amount by which your modified AGI exceeds the threshold, and rents are explicitly included alongside interest, dividends, and capital gains.⁹ Any gain when you sell the rental counts too.

The NIIT stacks on top of regular income tax. For a landlord in the 35% bracket, the combined federal rate on rental profits reaches 38.8% before state tax.

What Happens When You Sell

The Section 121 exclusion lets you exclude up to $250,000 of gain, or $500,000 for a married couple filing jointly, if the home was your principal residence for at least two of the five years before the sale.¹⁰ Converting the home to a rental starts the clock on that five-year window. Rent it for more than three years before selling and you fall outside the two-out-of-five-year use test and lose the exclusion.

The Non-Qualified Use Carve-Out

The law reduces the exclusion for periods of “non-qualified use,” but it specifically carves out the most common scenario. Any period after the last date you used the property as your principal residence is not treated as non-qualified use.¹⁰

So if you lived in the home for seven years, rented it for two, and sold, that two-year rental stretch does not reduce your exclusion. The reduction only applies to rental or investment use that came before your last stretch as principal residence. Buy and rent for three years, move in for two, rent for one more, then sell, and only those first three years are non-qualified. For a homeowner who has been living in the property and is now weighing whether to rent it out, the non-qualified use penalty likely does not apply at all, provided the sale happens within the five-year lookback and the two-year use requirement is met.

Depreciation Recapture Is Not Excluded

Even when Section 121 wipes out the capital gain, the depreciation you claimed (or should have claimed) is taxed separately. The gain tied to depreciation is “unrecaptured Section 1250 gain,” taxed at a maximum federal rate of 25%.¹¹ Straight-line depreciation on residential property keeps this from being reclassified as ordinary income, but it sits in its own category above long-term capital gains rates.

An example makes the shape clear. You claimed $30,000 of depreciation over the rental years and your total gain is $200,000. Section 121 can exclude up to $170,000 if you qualify, but the $30,000 of recapture is taxable regardless. At the 25% ceiling, that is $7,500 of federal tax on a sale that might otherwise cost you nothing. It is the price of the deductions you took each year.

Deferring the Rest With a 1031 Exchange

If gain exceeds what Section 121 covers, a like-kind exchange under Section 1031 can defer the taxable remainder. Because your converted home is now rental property, it qualifies as investment property for the exchange.

Revenue Procedure 2005-14 lets you use both provisions on the same sale: apply Section 121 first to exclude up to $250,000 or $500,000, then use Section 1031 to defer whatever taxable gain remains, including the depreciation recapture that Section 121 does not touch. The property has to satisfy both sets of tests, meaning the Section 121 two-out-of-five-year use and the Section 1031 requirement that the property be held for investment or business.

One later trap: if you take the replacement property through a 1031 exchange and eventually want to use the Section 121 exclusion on it, you must own it for at least five years first.¹⁰ The identification and closing deadlines on a 1031 exchange are strict, and missing one can convert deferred gain into fully taxable gain. A qualified intermediary is essential.

Forms and Records to Set Up From Day One

Renting the property adds forms beyond Schedule E:

Form 4562 each year to calculate depreciation and track remaining basis.¹²
Form 1099-NEC starting in 2026 for any non-corporate service provider you pay $2,000 or more during the year for work on the rental, whether property manager, contractor, or landscaper. The $2,000 counts the parts and materials the provider supplied, not just labor. Payments to corporations are exempt.¹³
Form 8960 if your modified AGI clears the $200,000 or $250,000 NIIT threshold, to calculate the 3.8% surtax on rental profits.⁹

Many cities and counties also require a landlord registration or business license before you can legally rent, and some impose transient occupancy taxes on short-term rentals; check locally before you take the first payment. Document the fair market value on the conversion date, every receipt for repairs and improvements, and, if you ever use the property yourself, a day-by-day log of personal versus rental use. The basis you set at conversion follows the property for decades, and reconstructing it later is much harder than capturing it now.

1
Internal Revenue Service. About Schedule E (Form 1040)
2
Internal Revenue Service. Publication 527 – Residential Rental Property
3
Internal Revenue Service. Tips on Rental Real Estate Income, Deductions and Recordkeeping
4
Internal Revenue Service. Tangible Property Final Regulations
5
Internal Revenue Service. Form 4562 – Depreciation and Amortization
6
Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
7
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
8
Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules
9
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
10
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
11
Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
12
Internal Revenue Service. Instructions for Form 4562 – Depreciation and Amortization
13
Internal Revenue Service. Publication 1099 (2026)