Your first rental property: Schedule E from day one
Depreciation is not optional, a repair and an improvement are treated very differently, and the loss you can use against other income has an income limit.
Quick answers
- Do I have to take depreciation on a rental?
- Yes, in practice. The gain when you sell is figured after reducing basis by the depreciation allowed or allowable, so skipping it costs you the deduction without protecting you later.
- Is a new roof a repair or an improvement?
- An improvement. Replacing a substantial structural part is a restoration, which must be capitalized and written off over time rather than deducted in the year you pay for it.
- Can a rental loss reduce my salary income?
- Sometimes. An owner who actively participates may use a limited special allowance against other income, and it phases out as modified adjusted gross income rises.
Rental income and expenses go on Schedule E, and the biggest expense on it is usually one you never write a check for. Depreciation spreads the cost of the building over a fixed number of years, and it is not optional.
| Recovery period in years for residential rental property under the general depreciation system | 27.5 | Publication 527, Table 2-1, MACRS Recovery Periods for Property Used in Rental Activities |
|---|---|---|
| Maximum special allowance for rental real estate with active participation | $25,000 | Publication 527, Maximum special allowance |
| Maximum special allowance, married filing separately and living apart all year | $12,500 | Publication 527, Maximum special allowance |
| Modified AGI up to which the full special allowance is available | $100,000 | Publication 527, Maximum special allowance |
| Modified AGI at or above which there is generally no special allowance | $150,000 | Publication 527, Maximum special allowance |
What goes on Schedule E
The rent you received is the income. Against it come the ordinary costs of owning and running the place: mortgage interest, property tax, insurance, repairs and maintenance, any utilities you pay, management and leasing fees, and depreciation. Schedule E carries the result through to your return alongside everything else. The lender's Form 1098 is where the interest figure comes from. If you are renting nightly on a platform rather than to a tenant on a lease, Airbnb and short-term rentals is the article for that.
Depreciation, and why it is not a choice
Residential rental property is depreciated over 27.5 years under the general depreciation system. Three points about the first year decide whether every year after it is right.
Land is not depreciable, so the purchase price has to be split between the land and the building, and only the building's share is written off. Depreciation begins when the property is placed in service, meaning when it is ready and available to rent rather than when a tenant signs or the first rent arrives. And a home converted from personal use depreciates from the lower of two amounts: what the property was worth on the day it changed use, or your adjusted basis that day. That last rule catches people out. A house bought years ago, in a market that has risen since, is generally depreciated from the older, lower amount rather than from what it is worth the day you list it.
Repairs versus improvements
Money spent on the property falls into two piles. An expense for repairing or maintaining the property may generally be deducted in the year you pay it, provided you are not required to capitalize it. Anything you pay to improve the property must be capitalized and written off over time instead.
Three things make a payment an improvement: it betters the property, it restores it, or it adapts the property to some new or different use. Bettering covers curing a defect that was already there, making the property larger, or raising its capacity, its strength or its quality. Restoring covers putting in a substantial structural part in place of an old one, or bringing the property back to a like-new condition. Adapting covers changing the property over to a use that does not sit with the ordinary use it had when renting began. Two provisions can pull smaller amounts back onto the deductible side, the de minimis safe harbor for tangible property and the safe harbor for routine maintenance, and both carry conditions worth reading before you rely on either.
The loss you can and cannot use
Expenses often exceed rent in a first year, and the loss is generally passive, which means it waits for passive income rather than reducing your salary. There is an exception for an owner who actively participates: a special allowance of up to $25,000 against other income, or $12,500 on a separate return where the spouses lived apart at all times during the year; a separate return from someone who lived with their spouse at any point in the year gets no allowance at all.
The allowance narrows as income rises. The full amount is available while your modified adjusted gross income is at or under $100,000. Above that, the allowance is limited to half the difference between $150,000 and your income. At or above $150,000, there is generally no special allowance at all. Each of those thresholds is halved for a married person filing separately.
A loss you cannot use this year is not lost. It is suspended and carried forward on Form 8582 until there is passive income to absorb it, or until you dispose of the property.
What happens when you sell
Depreciation reduces your basis whether or not you claimed it, since the reduction is for the amount allowed or allowable. So the gain on a sale is measured against a cost that has been falling every year, and it is larger than the difference between what you paid and what you sold for. Part of that gain, the part attributable to depreciation, is taxed differently from the rest. This is exactly why skipping depreciation does not help: you lose the deduction and face the same arithmetic anyway. Take the sale to a preparer, or to Publication 544, in the year before it happens rather than after.
The first-year checklist
Split the purchase price between land and building on a basis you can defend, and keep whatever you relied on to do it. Record the placed-in-service date while you still remember it, and open a separate account for the property so that next February is bookkeeping rather than archaeology. File improvement invoices apart from repair invoices, because only you know which pile each belongs in, and keep both for as long as you own the place and for a while after you sell it. Then set the depreciation schedule up correctly the first time, because every later year copies it.