Investing in real estate is a powerful way to build wealth and diversify your income, but many rental property owners miss out on valuable tax-saving opportunities. Whether you’re renting out a single unit or managing several properties, several strategies can help you minimize taxes on rental income, understand property tax on rental property, and save on capital gains taxes when you sell. With the right tax planning, options like depreciation, deductions, cost segregation, and 1031 exchanges can help you lower your tax bill now or defer taxes until later.
Understanding rental property taxes
Rental properties are taxed in two ways. First is rental income generated by renting out the property.
Most individual landlords use the cash method, where you report rental income when you receive it and deduct expenses when you pay them. However, you may use the accrual method and report income when it’s earned and deduct expenses when they’re incurred, according to the IRS guidelines.
The income generated by renting out the property is generally treated as ordinary income and taxed at your normal tax bracket rate. However, there are further rules for rental real estate income. Rental income is considered passive unless you are a real estate professional or qualify as someone who “materially participates” in rental activities. This passive income is not subject to FICA tax (commonly known as self-employment tax), but any passive losses will be limited to passive income, with any excess carried forward for future use.
The second way rental properties are taxed is when you sell a rental property. The tax on selling rental property may include capital gains tax and depreciation recapture (taxed at ordinary rates), depending on your profit and how long you have owned the property.
If you sell the property for less than you paid but for more than your adjusted basis — your basis reduced by depreciation deductions — you may still have a taxable gain because of the lowered basis, increasing your potential gain. In addition, any previously unused passive losses are also freed up with the sale and can be used to offset income.
For short-term capital gains tax rates (one year or less), the rate is the same as your ordinary income tax rate. For long-term capital gains tax rates (a year plus one day or longer), the rates are set at 0%, 15%, and 20%, depending on your taxable income. Some people may pay 0%, but most fall into the 15% range, with higher earners paying up to 20%. There are also special cases (like real estate or collectibles) that can be taxed at higher rates.
Key strategies for minimizing taxes
How do you avoid capital gains tax on rental property? You generally can’t completely avoid capital gains tax on a rental property, but you can defer, reduce, or strategically eliminate it using tools like 1031 exchanges, primary residence conversion, or estate planning.
For rental properties, tax planning is a key part of management. The best way to offset the taxes you owe is to keep track of all your expenses and take a holistic look at the value of your rental properties.
Here are some key strategies for minimizing your rental property taxes:
Depreciation benefits
When you rent out properties, you report your rental income and expenses on Schedule E (Form 1040) of your tax return, including the properties’ depreciation. The IRS allows you to deduct the decrease in a property's value over time due to wear and tear, spreading the deduction across years.
A cost segregation study can accelerate depreciation by identifying components of the property that can be depreciated over shorter time periods, such as 5, 7, or 15 years instead of the standard 27.5 or 39 years. This move can increase your deductions in the early years of ownership and improve your cash flow.
To qualify, the property must meet specific IRS criteria. Work with your tax advisor to figure out whether the property is depreciable, when it starts depreciating, and how the taxes surrounding it work.
Capital improvements vs. repairs
Not all property-related expenses are treated the same. Routine repairs (things like patching walls, fixing a shower faucet, or replacing a cracked window) are fully deductible in the year incurred. Capital improvements, on the other hand (such as adding a deck, installing a new HVAC system, or completely remodeling a kitchen) must be depreciated over time.
Misclassifying these expenses can cause you to miss out on immediate deductions and may even risk issues with the IRS. To stay compliant and maximize your deductions, keep detailed records to share with your tax advisor every year.
Use of tax-deferred exchanges
If you’re planning to sell one rental property and purchase another, you may want to consider a 1031 exchange (named after section 1031 of the IRS code), which allows investors to defer paying capital gains taxes if the proceeds from the sale are reinvested into a similar property.
For example, if you sell a rental property for $400,000 that has an adjusted basis of $250,000, your gain is $150,000. If you complete a 1031 exchange and reinvest the proceeds into a $500,000 replacement property, you can defer tax on that $150,000 gain rather than paying it in the year of sale.
Although 1031 exchanges have strict timelines and criteria, including that the property was used as a rental property and not just your primary home, using them correctly can be an effective tool to scale your portfolio while preserving capital.
Deduct your expenses
Rental property owners often overlook deductible expenses related to travel and day-to-day operations. In general, you can deduct “ordinary and necessary” expenses related to your rental. Commonly missed deductions include:
- Property management fees
- Legal and accounting services
- Advertising for tenants, including leasing commissions
- Landlord insurance
- HOA fees
- Home office expenses (if you manage rentals from a dedicated workspace at home)
Tax-loss harvesting
If you also invest in stocks or other assets, you can use tax-loss harvesting to offset gains with losses from those investments. For instance, if you sell a rental property at a gain, selling underperforming assets in the same year could help reduce your overall tax bill. Rental properties can also create tax losses through deductions like depreciation, mortgage interest, property taxes, and repairs. In many cases, those losses are considered passive losses, which generally can be used to offset passive income from other rental properties or passive investments. If your passive losses exceed your passive income, the unused amount is typically carried forward to future years. For more information on how tax-loss harvesting and passive loss rules apply to your situation, talk with your tax advisor.
Basis step-up upon death
If you’re planning to pass your property on to your heirs upon death, there’s an additional tax saving benefit for them, as your heirs’ basis in the property will be equal to the value at the time of your death. If your heirs then sell the property, there would be very little gain if sold shortly after inheritance due to the increased basis. If they hold and operate the rental property, they would then begin to depreciate the stepped-up basis (as opposed to carrying forward the existing depreciation schedule).
If you also own a vacation home, the way you title and structure ownership can affect estate planning, liability, and future tax treatment.
Qualified Business Income deduction
If you meet the safe harbor requirements, you can use the Qualified Business Income (QBI) deduction, which allows you to deduct up to 20% of your net rental income. To claim this benefit, the rental activity must meet certain IRS criteria, including the safe harbor requirements outlined in Revenue Procedure 2019-38 and Section 199A of the Tax Cuts and Jobs Act and made permanent in the .
Because eligibility depends on factors like recordkeeping, level of activity, and how the rental is structured, it’s important to work with a tax advisor to determine if your rental properties qualify.
Common mistakes to avoid
Even experienced rental property owners can fall into traps that reduce their tax efficiency. This includes:
- Misclassifying expenses: Treating capital improvements as repairs — or vice versa — can either shortchange your deductions or raise red flags during an audit.
- Failing to report all income: Income from short-term rentals, security deposits that aren’t returned, or rent paid in cash must all be reported.
- Neglecting depreciation: If you fail to claim depreciation, you not only miss a significant deduction, but you may still owe depreciation recapture when you sell, even if you didn’t benefit from the deduction.
Minimizing your rental property takes proactive planning, good recordkeeping, and a firm grasp of real estate tax rules. By leveraging the strategies above and working with experienced advisors, rental property owners can maximize deductions, defer taxes, and improve your bottom line.
READ MORE: Vacation Home Tax Rules: How Renting Out Your Property Affects Taxes