Owning a Rental: What Goes on Schedule E

The form

Schedule E is where rental real estate lives on a personal return. Each property gets its own column: the address, the number of days it was rented, the rent received, the expenses by category, and depreciation. The result — a profit or a loss per property — flows to the front of Form 1040 along with your wages and everything else.

This page is about the ordinary long-term rental: a tenant with a lease, a year at a time. Short-term rentals, renting a room in your own home, and vacation homes you also use yourself each play by different rules, and we have a page on those and another on second homes.

What counts as rental income

Rent, obviously. But also rent paid in advance, in the year you receive it rather than the year it covers. A payment a tenant makes to get out of a lease early. Any expense a tenant pays on your behalf — if they fix the furnace and deduct it from the rent, the full rent is income and the furnace is your repair expense. Property or services you accept in place of rent, at fair value.

A security deposit is not income when you receive it, because you intend to give it back. It becomes income only in the year you keep some or all of it.

What you can deduct

Anything ordinary and necessary to own and operate the property. The common ones:

One rule about interest is worth knowing because it cuts both ways. Interest follows the money, not the collateral. If you borrowed against your own home to buy the rental, that interest belongs on Schedule E even though the loan is secured by your house. If you borrowed against the rental to pay for a wedding, that interest is personal and deductible nowhere.

Repairs now, improvements over time

A repair keeps the property in its ordinary working condition: patching a roof, fixing a leak, repainting a room, replacing a broken window. It is deducted in full the year you pay it. An improvement makes the property better, bigger, or longer-lived: a new roof, a kitchen remodel, a new furnace, an addition. It is added to the property’s cost and deducted gradually through depreciation.

The line is not always clean, and there is a helpful safe harbor: an item that costs $2,500 or less, per invoice or per item, can be deducted in the year of purchase regardless of what it is. A $1,900 water heater is a current expense. A $9,000 furnace is not.

Depreciation is not optional

The building — not the land under it — is deducted over 27½ years, a slice each year, starting the month it was first available to rent. On a $400,000 purchase where the land is worth $80,000, that is roughly $11,600 a year, every year, whether or not you spent a dollar on the place.

Some owners skip it, thinking they are saving the deduction for later or keeping things simple. That is a mistake, and an expensive one. When you sell, the tax law treats you as having taken the depreciation whether you did or not — the rule is allowed or allowable — and taxes the recapture either way. Skipping it means paying tax later on a deduction you never got. We have a separate page on what a sale really costs.

The paper loss, and who gets to use it

Depreciation is the reason people buy rentals for tax purposes. It is a deduction with no check written: the rent comes in, the mortgage and taxes go out, the property may well be putting cash in your pocket — and the return still shows a loss, because $11,600 of depreciation sits on top of the real expenses. That paper loss is what landlords are counting on to shelter the rent and, they hope, some of their salary too.

Here is the part the seminar skipped. Whether you can use that loss against your other income depends on your income. If your adjusted gross income is $100,000 or less, you can deduct up to $25,000 of rental loss against wages and everything else. Between $100,000 and $150,000 the allowance phases out, two dollars of allowance lost for every dollar over. At $150,000 and above, no rental loss is deductible against other income at all — not the depreciation, not the interest, none of it, however real the numbers are.

That is not the end of the story; the suspended losses come back later, as explained below. But a landlord who bought the property expecting the depreciation to cut this year’s tax bill, and who earns more than $150,000, is going to be disappointed in April. It is one of the first things we ask about when someone tells us they are thinking of buying a rental.

Why the loss on paper may not show up on your return

Between the mortgage interest and the depreciation, a rental often shows a loss on Schedule E even when the rent covers the payment and then some. Whether that loss reduces the tax on your wages depends on a set of rules Congress wrote in 1986 to stop exactly that.

Rental real estate is treated as a passive activity by definition, and passive losses can offset only passive income — the profit from another rental, say — not wages, interest, or capital gains. There are two ways out.

The $25,000 allowance

If you actively participate in the rental — approve tenants, set the rent, sign off on repairs, even with a manager doing the day-to-day — you can deduct up to $25,000 of rental losses against your other income. The allowance is full when your modified adjusted gross income is $100,000 or less, shrinks by one dollar for every two dollars above that, and is gone at $150,000. Those figures were set in 1986 and have never been adjusted for inflation, which is why so many two-income households find themselves past the limit. Married couples filing separately get half, and only if they lived apart all year.

The real estate professional exception

Someone who spends more than half their working hours, and at least 750 hours a year, in real estate businesses — and who also materially participates in the rentals themselves — is not subject to the passive rules at all. Their rental losses are deductible in full. This is the rule for people whose job is real estate: agents, developers, full-time landlords. It is very hard to meet alongside a full-time job elsewhere, and the IRS examines these claims closely. The courts have thrown out hour counts reconstructed after the fact; the log has to be kept as the year goes along. Spouses can combine hours for the participation test but not for the 750-hour test.

What happens to the rest

Losses you cannot use are suspended, not lost. They carry forward and come out in one of two ways: against passive income in a later year, or in full in the year you sell the property to an unrelated buyer in a taxable sale. A landlord with a decade of suspended losses often finds that the year of sale, which they expected to be the expensive one, is partly sheltered by all the losses they were never able to take.

Form 8582: where the suspended losses live

The running total of losses you have not been able to use is kept on Form 8582, which is filed with your return every year a rental shows a loss. Each year it adds the new disallowed loss to the old ones and carries the total forward. By the time a property is sold, that form may be holding tens of thousands of dollars of deductions waiting to be released.

And here is where real money gets lost. Form 8582 is the piece most often dropped when a taxpayer changes preparers. The new preparer sees the current year’s rent, expenses and depreciation and prepares the return from those. Unless someone goes looking for the prior year’s Form 8582 and brings the carryforward over, the suspended losses simply vanish from the record. Nothing flags the error. The return is accepted. Years later the property is sold, and the losses that should have sheltered the gain are nowhere to be found — because for several years nobody carried them.

The same goes for the depreciation schedule. Both documents follow the property, not the preparer, and both are the first things we ask for when a new client brings us a rental.

Two more things on the income side

The 20% deduction. Rental income can qualify for the qualified business income deduction if the rental rises to the level of a business. The IRS offers a safe harbor for owners who spend 250 hours a year on rental services, with records, and keep separate books. A single property with a manager usually does not qualify; several properties you run yourself may. More on the QBI deduction.

The 3.8% tax. Above $200,000 of income ($250,000 married), net rental income is subject to the net investment income tax on top of regular tax. It does not apply to real estate professionals. It is one of the items on our page for high earners.

Three things people ask

“Should I put the rental in an LLC?”

That is a liability question for your attorney, not a tax question. An LLC you own by yourself is invisible to the IRS: the rental still goes on Schedule E of your personal return, with the same income, the same deductions, and the same loss limits. The LLC changes nothing on the tax side.

“I rent to my daughter for less than it’s worth.”

Then it is not a rental in the eyes of the tax law. Days rented to a relative below fair market rent count as personal use, which means no loss is allowed and the deductions are limited to the rent received. Charging a relative a fair rent, and being able to show it is fair, keeps the property a rental.

“Do I pay self-employment tax on the rent?”

No. Rental income is not earned income, so it is not subject to the 15.3% self-employment tax that a Schedule C business pays. That is one of the quiet advantages of rental property. The other side of the coin is that rental income does not count as earned income for IRA or 401(k) contributions, and does not earn Social Security credits.

Colorado

Colorado taxes rental income the same way it taxes everything else, starting from the federal figure. If the property is in another state, that state will generally want a return and its share of tax on the rental income, and Colorado gives you a credit so the same income is not taxed twice. If you live elsewhere and own a Colorado rental, the same thing happens in reverse.

Records that matter

• The closing statement from the purchase. Keep it for as long as you own the property and for several years after you sell. It sets the cost basis that every depreciation figure and the eventual gain depend on.
• Receipts for every improvement, for the same reason.
• A mileage log for trips to the property.
• A record of what you did and when, if you are relying on the active participation rule, the real estate professional rule, or the 250-hour safe harbor. Calendars and emails count. A summary written in April does not.
• Every year’s Form 8582 and depreciation schedule. If you change preparers, these two pages are what the new one needs most.

Rental losses are one of the items the IRS looks at closely. Our audit red flags page explains why.