Real Estate Rentals: How the Money Actually Moves
Rent in, expenses out, depreciation on paper, and a set of loss rules that may quietly park your deduction for later
Open interactive version (quiz + challenge)Real-world analogy
A rental is a small shop that sells one product: shelter, by the month. Like any shop, the till total is not the profit. Rent is the till. Tax, insurance, repairs, vacancy and management are the costs of keeping the shutter open. And there is one strange expense you never actually pay in cash — depreciation — which the tax code lets you claim as the building wears out.
What is it?
A residential rental is property you own and rent to others, reported on Schedule E of your federal return. You report the rent you receive, deduct ordinary and necessary operating expenses, and separately depreciate the BUILDING (not the land) over 27.5 years using straight-line depreciation. IRS Publication 527 sets out when the clock starts: "You can begin to depreciate rental property when it is ready and available for rent" — not when the first tenant signs.
Real-world relevance
The practical shape of a rental year: a lease, twelve rent payments that are hopefully on time, one or two repairs, an insurance renewal, a property tax bill, and a tax return where the paper depreciation deduction often turns a cash-positive property into a taxable loss. Then the rules that catch people: the passive activity limits may suspend that loss instead of letting you use it, and every dollar of depreciation you claim reduces your basis and comes back as recapture when you sell — the mechanic you saw in lesson 4.
Key points
- Repairs are deducted now; improvements are depreciated over years — Fixing a leaking tap is a repair, deducted this year. Replacing the whole roof is a capital improvement, added to basis and depreciated. The distinction is not about the amount you spent — it is about whether the work restores the property or betters, restores or adapts it to a new use.
- You depreciate the building, never the land — Land does not wear out, so it is not depreciable. You must allocate the purchase price between land and building — commonly using the ratio on the county assessment — and only the building portion gets the 27.5-year residential schedule. Commercial property runs 39 years.
- Depreciation starts when the property is ready and available for rent — Placed in service, not first tenant. A unit finished and listed on 1 September starts depreciating on 1 September even if it sits empty until November. Getting this date wrong shifts a real deduction into the wrong tax year.
- Rental losses may be suspended, not lost — Rental activity is generally passive. Under IRS Publication 925 an active participant may take up to $25,000 of loss against other income, phased out between $100,000 and $150,000 of modified AGI. Losses you cannot use are suspended and carried forward — usually freed up when you dispose of the property.
- ⚠️ Common misconception: 'The security deposit is income when I receive it' — It is not, if you intend to return it — it is a liability you are holding. It becomes income in the year you keep it, for example applied to unpaid rent or damage. Advance rent, on the other hand, IS income in the year you receive it, even if it covers next year.
- Fair housing law is not optional and not negotiable — The federal Fair Housing Act prohibits discrimination in housing because of race, color, national origin, religion, sex, familial status or disability — seven protected classes. Many states and cities add more, such as source of income. Screening criteria must be written, consistent and applied to every applicant identically.
Code example
ONE RENTAL YEAR: CASH FLOW vs TAXABLE INCOME
=============================================
(Illustrative. Your facts and rates will differ.)
THE PROPERTY
Purchase price ................. $275,000
Land portion (per assessment) .. $ 55,000
Building (depreciable) ......... $220,000
Annual depreciation
= $220,000 / 27.5 ............ $ 8,000
CASH SIDE OF THE YEAR
Rent collected (12 x $1,900) ... $ 22,800
Property tax ................... -$ 3,400
Insurance ...................... -$ 1,450
Repairs ........................ -$ 1,900
Management ..................... -$ 1,824
Mortgage INTEREST .............. -$ 9,100
Mortgage PRINCIPAL ............. -$ 3,300
---------------------------------------
CASH IN YOUR POCKET ............ $ 1,826
TAX SIDE OF THE SAME YEAR (Schedule E)
Rental income .................. $ 22,800
Property tax ................... -$ 3,400
Insurance ...................... -$ 1,450
Repairs ........................ -$ 1,900
Management ..................... -$ 1,824
Mortgage interest .............. -$ 9,100
Depreciation (no cash paid) .... -$ 8,000
Principal is NOT deductible .... $ 0
---------------------------------------
TAXABLE RESULT ................. -$ 2,874
(a LOSS)
SO: +$1,826 in your bank
-$2,874 on your tax return
Both are true. Depreciation and the
non-deductible principal payment are the
entire difference.
AND REMEMBER: that $8,000 of depreciation
reduces your basis, so it comes back as
recapture on the day you sell.Line-by-line walkthrough
- 1. First, split the purchase price between land and building. Only the $220,000 building depreciates, at $220,000 divided by 27.5 years = $8,000 a year.
- 2. On the CASH side, everything you actually pay leaves the account — including the mortgage principal — so $1,826 is what genuinely accumulates over the year.
- 3. On the TAX side, two lines behave differently. Mortgage principal is not a deductible expense (it is repaying a loan, not a cost of operating), so it disappears from the tax column.
- 4. Depreciation appears in the tax column even though no money moved. That single $8,000 line is what flips a cash-positive property to a taxable loss of $2,874.
- 5. Both numbers are correct at the same time. Cash flow answers 'can I pay the bills'; taxable income answers 'what do I owe'. Confusing the two is how landlords end up surprised in both directions.
- 6. OUTCOME: whether you can actually USE that $2,874 loss depends on the passive activity rules — up to $25,000 for active participants, phasing out between $100,000 and $150,000 of modified AGI. And the $8,000 of depreciation is borrowed, not given: it reduces basis and returns as unrecaptured Section 1250 gain when you sell.
Spot the bug
Landlord's plan: 'I am not going to claim depreciation on my rental. I would rather show more income now, and that way there is no depreciation recapture to pay when I sell in fifteen years.'Need a hint?
Look up the exact phrase the recapture rules use about depreciation that was not taken.
Show answer
This strategy pays twice and saves nothing. Depreciation recapture applies to depreciation ALLOWED OR ALLOWABLE — meaning the basis reduction happens whether or not you actually claimed the deduction. So this landlord gives up fifteen years of real deductions AND still faces recapture computed as if they had taken them. It is the single worst possible ordering. If depreciation was genuinely missed in prior years, the fix is not to keep ignoring it; a tax professional can look at correcting the accounting method (Form 3115) rather than simply amending forever. And note the second error hiding underneath: 'more income now' also means more tax now, at ordinary rates, which is usually higher than the recapture rate later.
Explain like I'm 5
When you rent out a house, people pay you rent every month. But you also pay for repairs, insurance and taxes, so you keep less than the rent. The government also lets you count a little bit of the building 'wearing out' every year as a cost, even though you did not pay anyone for it. That makes your taxes smaller now — but when you sell the house one day, they add that part back up.
Fun fact
Residential rental buildings are depreciated over 27.5 years and commercial buildings over 39 years — but land is never depreciated at all, no matter how long you hold it. That is why the land-to-building split on your purchase, usually taken from the county assessment ratio, quietly determines thousands of dollars of deductions across the life of a rental.
Hands-on challenge
Take any rental you own or are considering and build both columns for one year: the cash column and the Schedule E column. The two numbers will differ, and the gap should be explained entirely by depreciation plus the non-deductible principal portion of your mortgage payment. If you cannot make the gap reconcile to those two items, something in your expense list is misclassified — find it now, not in April.