A rental can build wealth, but whether it pays depends on cash flow and tax rules you should model before you sign anything. Three rules shape the numbers: the building (not the land) is depreciated over 27.5 years; rental losses can offset up to $25,000 of your other income only if your income is under $150,000; and the depreciation you took is taxed at up to 25% when you sell.
Two ways in, two different plans
Keeping your current home and renting it out. This is how many people become landlords, often by accident after a move. The trap is the home-sale exclusion. You can exclude up to $250,000 of gain ($500,000 for a married couple) only if you owned and lived in the home at least 24 months of the five years before the sale. Once you move out, that clock runs. Sell within about three years and you keep the exclusion, apart from depreciation taken while it was rented, which is taxed. Wait longer and the whole gain can be taxable.
Buying a property to rent. Here the question is whether the rent covers the full cost of owning it, and whether this is a better use of the money than the alternatives. Lenders usually price loans on investment property differently from loans on a home you live in, so get a quote for the right loan type before you run the numbers.
Either way, tell your insurer. A policy written for a home you live in may not cover a home you rent out.
The tax rules that shape the numbers
Reporting. Rent and expenses go on Schedule E. You can deduct ordinary costs of managing and maintaining the property from the time it’s available for rent: mortgage interest, property tax, insurance, repairs, management fees and depreciation. A security deposit you plan to return isn’t income; any part you keep is income in the year you keep it.
Depreciation. You recover the cost of the building over 27.5 years. Land can’t be depreciated, so the split between land and building matters. Appliances, carpets and furniture used in the rental are depreciated over 5 years. Depreciation lowers your tax each year, but it also lowers your cost basis, which raises the taxable gain when you sell.
The tax when you sell. The part of your gain that comes from depreciation, called unrecaptured section 1250 gain, is taxed at up to 25%. The rest is taxed as a capital gain.
Limits on losses. Rentals are passive activities, so losses generally can’t offset your salary. The exception: if you actively participate, meaning you make real management decisions such as approving tenants, setting rents and approving expenses, you can deduct up to $25,000 of rental losses against other income.
Losses you can’t use aren’t lost. They carry forward to later years and can offset rental income or a gain when you sell.
The 3.8% tax. Rents and gains from selling real estate count as net investment income. Above $200,000 of modified adjusted gross income for a single filer or $250,000 for a married couple filing jointly, a 3.8% net investment income tax applies to the lesser of that income or the amount over the threshold.
Deferring the tax with an exchange. A like-kind exchange, often called a 1031 exchange, lets you sell a rental and buy another investment property without paying tax on the gain now. You must identify the replacement within 45 days and receive it within 180 days, or by your tax return’s due date if earlier. Personal homes and vacation homes don’t qualify.
The law on tenants. The federal Fair Housing Act bars discrimination in housing because of race, color, national origin, religion, sex, familial status or disability. States and cities add their own rules on deposits, notice and eviction, so read your local landlord-tenant law before you write a lease.
Run the cash flow before you sign
Write down a year of real numbers, not the listing’s estimate:
- Rent you can actually get, minus a reserve for months it sits empty
- Mortgage payment, property tax, insurance and HOA fees
- Repairs and replacement of big items such as the roof, water heater and appliances
- Property management, if you won’t do it yourself
- Your time, if you will
Then compare the result with what the same money would earn elsewhere. A rental that breaks even on cash can still make sense if the mortgage is being paid down and the property gains value. It’s a worse deal if a vacancy or a repair would force you to borrow.
Common mistakes
- Renting out the old home without watching the three-year window, and losing a tax-free sale.
- Assuming losses will cut your tax when your income is above $150,000. They’ll mostly carry forward instead.
- Skipping depreciation. It reduces your basis when you sell whether or not you claimed it, so not claiming it costs you twice.
- No cash reserve. One vacancy plus one repair can wipe out a year of profit.
- Mixing money. Keep a separate account for each rental so expenses are easy to prove.
Questions to ask an advisor
| Ask | A good answer includes |
|---|---|
| Does this rental beat my alternatives after tax? | A year of cash flow and a comparison with investing the money |
| Will my losses be deductible at my income? | The $25,000 allowance and how my income affects it |
| What’s my tax if I sell in 3, 5 or 10 years? | Depreciation recapture, capital gains and the 3.8% tax |
| Should I keep my old home or sell before the window closes? | The exclusion deadline in dates |
| How are you paid? | A fee from me, nothing from property sales, loans or insurance |
When advice is worth it, and what it costs
You’ll want a CPA or enrolled agent for the tax return; Schedule E, depreciation and passive losses are where errors happen. A fee-only financial planner answers a different question: whether the rental fits your goals, how to finance it, how much cash to keep and when to sell. Our guide to CFP vs CFA vs CPA explains who does what.
For a single decision, most people pay by the hour or for a one-time plan. Fee-only planners charge a median $300 an hour (middle half $250 to $350) and $2,000 for a one-time plan. If you hold several properties and want ongoing advice, the median ongoing planning fee is $4,500 a year. A flat fee suits landlords well: an advisor paid a percentage of the assets they manage isn’t paid on your real estate, so it can get less attention.
How to find one
In the public graph, start with the real estate investors specialty, the lists of advisors for real estate investors and real estate investing specialists, or the real estate investors audience page. If the rentals become a business, our guide for small business owners covers the rest. If you haven’t bought your own home yet, start with buying your first home.