One of the most common topics clients ask us about at Sigma CPAs is rental real estate. Many individuals are drawn to the idea of becoming a landlord and earning passive income, often envisioning it as a simple way to build wealth. And while owning rental property can indeed be a powerful component of a long-term wealth strategy—and a valuable source of supplemental income—it’s important not to dive in without proper planning.
Jumping into real estate investing without a solid understanding of rental property operations and the tax implications can lead to costly mistakes. As with most areas of tax strategy, real estate has its share of niche rules and complexities. If you’re considering investing in rental property in Jackson, TN or the surrounding areas, consider this your beginner’s guide to the essential financial and tax considerations you need to know first.
Deductible Expenses: What Can Be Used to Offset Rental Income?
In a previous post about freelance income, we emphasized the importance of maintaining detailed and organized records of business expenses. That same principle applies to rental property owners—especially those looking to maximize their tax deductions and reduce taxable rental income.
While this isn’t an exhaustive list, here are some of the most common deductible expenses landlords can claim to offset rental income:
Mortgage Interest – Although the full cost of purchasing the property isn’t deductible all at once (we’ll touch more on depreciation later), the interest paid on the mortgage is generally deductible. Your mortgage lender should provide a year-end tax form, but it's also wise to personally track your mortgage interest payments throughout the year.
Property Taxes – Annual property tax payments on your rental property can be deducted as a rental expense.
Insurance – Premiums for landlord or rental property insurance policies are deductible.
Utilities – If you, as the landlord, pay for utilities—either during vacancies or as part of a lease agreement—those costs can be deducted.
Repairs and Maintenance – Ordinary repairs that keep the property in good condition (e.g., fixing leaks, repainting, replacing broken fixtures) are deductible.
Property Management Fees – If you use a property management company to oversee your rental, their fees are fully deductible.
Pest Control – Regular pest control services are considered maintenance and can be written off as an operating expense.
What Is Depreciation, and How Does It Impact My Taxes?
Earlier, we noted that while mortgage interest is immediately deductible, the purchase price of a rental property is not. So what happens to that cost? It’s handled through depreciation—a key concept in real estate tax strategy.
Depreciation is the process of spreading out the cost of a long-term asset—such as a rental property—over its useful life(typically 27.5 years for residential real estate). Instead of deducting the entire purchase price in the year you acquire the property, you deduct a portion of it each year, reducing your taxable rental income annually over time.
It’s essential to understand what gets capitalized and depreciated versus what can be expensed immediately. A helpful rule of thumb: if the cost is related to regular operations or minor upkeep—like a small repair—it can usually be deducted in the year it’s incurred. However, if the improvement adds value to the property or extends its useful life—such as a full kitchen or bathroom renovation—it’s typically capitalized and depreciated over time.
Before starting any major renovation on your rental property, don’t assume you’ll be able to deduct the entire cost in the current tax year.
Understanding Passive Activity Loss Rules
So what happens if your rental property shows a loss after depreciation? In some cases, these losses can be used to offset other types of income—but, as you might expect, it’s not quite that straightforward.
In most cases, rental real estate is considered a passive activity by the IRS. That means there are specific limitations on how and when you can use passive losses to reduce your taxable income.
Usually, rental real estate is considered a passive activity. As such, the IRS places limits on the losses you can use. For those with an adjusted gross income of $100,000 or less, it’s pretty straightforward: you’re allowed to deduct up to $25,000 of rental losses against your ordinary income. For those with an adjusted gross income between $100,000 and $150,000, there is a phaseout, meaning the amount of loss you can deduct is gradually reduced. Once your income exceeds $150,000, you are completely phased out from using these losses to offset your ordinary income.
For high-income individuals and business owners, this rule makes it crucial to plan carefully when it comes to leveraging rental property losses. With proper tax planning strategies, including real estate professional status or grouping elections, we can often help mitigate the impact of these limits.
What Happens If I Want to Sell a Rental Property?
Rental real estate provides two main opportunities to build wealth: rental income and capital appreciation. While rental income is often the initial draw for investors, over time, the property itself may also increase in value. When the time comes to sell your rental property, there are a few important tax considerations to keep in mind.
Like any capital asset, the tax treatment of your rental property sale depends on how long you’ve owned it. If you hold the property for less than one year, any profit from the sale is considered a short-term capital gain and taxed at your ordinary income tax rate. This is generally less favorable, but it rarely applies if you've used the property as a true rental. To take advantage of long-term capital gains tax rates, you must own the property for more than one yearbefore selling.
However, the capital gains rate is only part of the picture. Remember depreciation? This is where it becomes relevant again. When you sell a rental property that you’ve depreciated over the years, the IRS requires you to recapture that depreciation, and it’s taxed differently.
Here’s an example:
Suppose you purchased a rental property for $200,000 and, over the years, claimed $50,000 in depreciation. That means your adjusted basis in the property is now $150,000. If you sell the property for $250,000, you have a total gain of $100,000.
The $50,000 of depreciation you previously claimed will be recaptured and taxed at a rate of up to 25%. This is because real estate is considered Section 1250 property.
The remaining $50,000 gain, which exceeds your original purchase price, is generally taxed at the long-term capital gains rate, which is typically lower than your ordinary income rate.
What Is a 1031 Exchange?
A 1031 Exchange—also known as a like-kind exchange—is a powerful tax-deferral strategy that allows real estate investors to defer capital gains taxes when they sell one investment property and reinvest the proceeds into another similar property.
While the concept sounds simple, the process is complex and highly time-sensitive, so it's important to follow the IRS guidelines carefully. (We’ll cover this in more detail in a future post, but here’s a simplified overview.)
In a 1031 Exchange, the property you’re selling and the property you're buying must be “like-kind”—which typically means investment or income-producing real estate, such as exchanging one residential rental property for another.
When the original property is sold:
You cannot take possession of the proceeds. The funds must go directly to a qualified intermediary, a neutral third party who holds the money during the exchange.
You have 45 days from the date of the sale to identify the replacement property in writing and notify your intermediary.
You then have 180 days from the sale of your original property to close on the purchase of the new property.
If all of these steps are completed properly, you can defer the capital gains taxes that would otherwise be due on the sale of the original property.
Is Rental Real Estate Right for Your Tax Strategy?
What you've just read is only the beginning when it comes to understanding the tax implications of rental real estate investing. There are many other important considerations that can vary depending on your unique financial situation, income level, and investment goals.
Think of this as a beginner’s crash course—a high-level overview designed to introduce you to the key concepts, opportunities, and potential pitfalls of owning and managing rental property. As you’ve seen, while rental real estate can be a powerful tool for building wealth and reducing taxes, it also comes with a fair amount of complexity.
If you’re an active or aspiring real estate investor, working with experienced tax professionals is essential to navigating these complexities. At Sigma CPAs, we specialize in helping investors in Jackson, TN and surrounding areas optimize your real estate portfolio, maximize tax benefits, and develop long-term strategies that protect and grow your wealth. Whether you’re managing multiple properties or just starting out, we provide tailored guidance to keep your investments working efficiently within your overall financial plan.