Rental property course · Lesson 4 of 6
Depreciation lowers the tax on a rental, within limits.
The tax result of a rental is different from its cash result. Depreciation is the reason. The passive loss rules then decide how much of a tax loss you can use.
Depreciation
| Basis | $ |
|---|---|
| Price | 300,000 |
| Settlement costs that add to basis | 6,000 |
| Cost of the property | 306,000 |
| Land, 20%, not depreciated | (61,200) |
| House, depreciated over 27.5 years | 244,800 |
The tax law spreads the cost of a residential rental over 27.5 years, in equal parts. Land does not wear out, so you cannot depreciate it. Split the cost between land and house by their values. The tax assessor’s split is one accepted method.
Example House depreciates $8,902 a year. It goes into service in January, and the mid-month rule counts that first month as half a month. So year 1 gets $8,531.
A larger loss for tax than in cash
| Year 1, for tax | $ |
|---|---|
| Net operating income | 17,371 |
| Mortgage interest | (15,678) |
| Depreciation | (8,531) |
| Rental result for tax | (6,837) |
Only the interest part of the payment is a cost for tax. The principal is not. But depreciation is a cost for tax, and it uses no cash. So Example House loses $592 of cash in year 1, but $6,837 for tax. From year 3, it has positive cash and still a loss for tax.
The passive loss rules
A rental is a passive activity. A passive loss usually cannot reduce your wages. There is one exception for owners who take part in the management, for example by approval of new tenants. For them, up to $25,000 of loss a year can reduce other income.
The $25,000 falls by 50% of your modified AGI above $100,000. At $150,000, nothing is left.
| Modified AGI | Allowance |
|---|---|
| $100,000 | $25,000 |
| $120,000 | $15,000 |
| $140,000 | $5,000 |
| $150,000 | $0 |
The household in this course has modified AGI of $140,000, so its allowance is $5,000. In year 1 it uses $5,000 of the loss and saves $1,100 of tax at its 22% rate. The other $1,837 carries forward.
Losses carried forward
| Year | Cash flow | Result for tax | Loss used | Loss carried | Tax saved or (paid) |
|---|---|---|---|---|---|
| 1 | (592) | (6,837) | 5,000 | 1,837 | 1,100 |
| 2 | (71) | (6,522) | 5,000 | 3,359 | 1,100 |
| 3 | 466 | (5,808) | 5,000 | 4,167 | 1,100 |
| 4 | 1,019 | (5,065) | 5,000 | 4,232 | 1,100 |
| 5 | 1,588 | (4,292) | 5,000 | 3,524 | 1,100 |
| 6 | 2,175 | (3,487) | 5,000 | 2,011 | 1,100 |
| 7 | 2,779 | (2,649) | 4,660 | 0 | 1,025 |
| 8 | 3,401 | (1,775) | 1,775 | 0 | 391 |
| 9 | 4,042 | (865) | 865 | 0 | 190 |
| 10 | 4,702 | 455 | 0 | 0 | (100) |
A loss that you cannot use carries forward to later years. Example House uses up its carried losses by year 7. A loss that is still carried when you sell all of the property is deductible in full in the year of the sale.
Above $150,000 of modified AGI, a household gets no allowance. Its losses all carry forward until the rental makes a profit for tax, or until the sale.
Key points
- Depreciate the house over 27.5 years. Do not depreciate the land.
- Depreciation can give a loss for tax while the property gives positive cash.
- The $25,000 allowance falls to zero between $100,000 and $150,000 of modified AGI.
Sources
- IRS, Publication 527, Residential Rental Property, for the 27.5-year recovery period, the straight line method and mid-month convention, land, and the settlement costs that add to basis.
- IRS, Publication 925, Passive Activity and At-Risk Rules, for the $25,000 allowance, its reduction above $100,000 of modified AGI, and active participation.
- IRS, Topic 425, Passive Activities, Losses and Credits, for losses carried forward and their deduction when you sell your entire interest.
- IRS, IR-2025-103, Tax Inflation Adjustments for Tax Year 2026, for the standard deduction of $32,200 and the 22% bracket for married couples with a joint return.