Depreciation is a deduction you take without spending anything. It is big enough that a rental can hand you money every month and still report a loss to the IRS.
Whether that loss lowers the tax on your salary is a separate question, and it has a dollar figure attached: $25,000, with a limit that depends on your income.
Why does a rental that pays you report a loss?
Two of the largest lines on a rental’s tax return don’t match what leaves your bank account.
The first is the mortgage. The whole payment leaves your account, but only the interest part is deductible. The principal is you buying the house a little at a time, so it never reaches the return.
The second is depreciation. The IRS treats a residential rental building as wearing out over 27.5 years and lets you deduct a slice of it every year, whether anything wore out or not. Land isn’t depreciable, so you split the purchase price between the land and the building first, and IRS Publication 527 says you may use the county’s assessed values to do it when market values are unclear.
Take a $400,000 house renting for $4,000 a month, bought with 20% down on a 30-year loan at 7.25%. The example budgets 5% vacancy, $4,800 of property tax, $2,100 of insurance, 5% of rent for maintenance, another 5% for the CapEx reserve and 8% for a property manager. The county puts 80% of the value on the building, so $320,000 over 27.5 years is $11,636 of depreciation a year.
| What you bank | What the return shows | |
|---|---|---|
| Rent after empty months | $45,600 | $45,600 |
| Running costs | −$15,540 | −$13,140 |
| Mortgage | −$26,196 | −$23,098 |
| Depreciation on the building | – | −$11,636 |
| For the year | +$3,864 | −$2,274 |
These are example figures, not a forecast for any market. The rates and costs are the example’s own assumptions.
The two columns differ in three places. The cash column takes the full $26,196 of payments; the tax column takes only the $23,098 of interest. The cash column holds $2,400 set aside for a future roof, which isn’t a deduction until it is spent, and a roof is an improvement you depreciate rather than a repair you write off. And the tax column carries $11,636 that never left your account.
The cash side is the one that pays the mortgage every month, so work it out first: how to calculate cash flow on a rental property walks through it line by line, and how much to save for maintenance covers the two set-aside rows.
What are the passive activity loss rules?
“A rental activity is a passive activity even if you materially participated in that activity.” That line is from IRS Publication 925, the edition for 2025 returns, and it is the starting point for everything below.
Passive losses offset passive income. Left there, the $2,274 would sit and wait for passive income to appear, which for most landlords means waiting for another rental to turn a taxable profit.
Rental real estate gets an exception, and it is the reason this question has an answer at all.
Who can deduct up to $25,000 of rental losses?
Publication 925 says that if you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from nonpassive income. Nonpassive income is the ordinary kind: wages, a salary, self-employment earnings.
Active participation is a softer test than material participation. The publication’s own examples are approving new tenants, deciding on rental terms and approving expenditures. You and your spouse together have to hold at least 10% by value of all interests in the activity throughout the year, and a limited partner generally isn’t treated as actively participating.
Filing separately changes the figure. The allowance is $12,500 if you are married filing separately and lived apart from your spouse for the entire year, and you can’t use it at all if you filed separately and lived together at any point in the year.
What happens when your income passes $100,000?
The allowance starts shrinking once modified adjusted gross income passes $100,000. Publication 925 reduces it by 50% of the income above that line, so it reaches zero at $150,000. For married filing separately, the same squeeze runs from $50,000 to $75,000.
Here is the example’s $2,274 loss against four incomes.
| Modified AGI | Allowance left | The $2,274 loss | |
|---|---|---|---|
| $90,000 | $25,000 | Deducted this year | |
| $120,000 | $15,000 | Deducted this year | |
| $145,000 | $2,500 | Deducted this year | |
| $150,000 or more | Nothing | Carried forward |
One house rarely runs into the $25,000 ceiling. Five houses like this one would report about $11,370 of losses between them, still well inside it. The line most people hit is the income phase-out, not the dollar cap, which is why a landlord earning $160,000 and a landlord earning $80,000 can own the same house and get a different answer.
A loss you can’t use isn’t a loss you gave up, though, and that is worth knowing before you decide a rental is only worth owning for cash flow. Is a negative cash flow rental property worth it? runs the other half of that question.
Where does an unused loss go?
It carries forward. Publication 925 says a disallowed loss is carried over to the next year, allocated among your activities and treated as a deduction from the same activity in that year. Nothing expires while you hold the property.
Selling releases it. Under the publication’s rules on dispositions, unused passive losses, including the current year’s, are generally allowed in full in the year you dispose of your entire interest in the activity, as long as all realized gain or loss is recognized and the buyer isn’t related to you. Years of suspended losses can land on one return that way.
What if real estate is your job?
There is a second route out of the passive rules, and it is a high bar. Publication 925 treats you as a real estate professional for a year only if both tests are met: more than half of the personal services you performed in all trades or businesses were in real property trades or businesses in which you materially participated, and you performed more than 750 hours of services in those businesses during the year.
Work you did as an employee generally doesn’t count unless you owned more than 5% of your employer, and on a joint return your spouse’s services don’t count toward either test. Clear both and your rental losses stop being passive, so the $25,000 allowance and the income phase-out no longer apply to you.
What should you work out first?
Get the cash line right before you touch any of this. Put the price, rent, taxes, insurance and set-asides into the rental calculator and see what the house pays you, because that number decides whether you can hold it. The tax side only changes what you keep.
Then do the depreciation by hand once, the way the table above does, and check it against the allowance and the phase-out for your own income. The rules are the rules, but your return has your whole financial life on it, so take the figures to a tax professional before you file.