Rental income is taxable regardless of whether you have a mortgage on the property

The mortgage itself does not reduce your taxable rental income. What matters for taxes is the difference between what tenants pay you and what you spend to operate the property. The IRS taxes your net rental income—the money left after you subtract allowable expenses. A mortgage payment is split into two parts: principal (which is not deductible) and interest (which is). Only the interest portion counts as a deductible expense.

This means you could owe taxes on rental income even in years when your mortgage payment exceeds what you collected in rent. For example, if you collected $12,000 in rent but paid $15,000 in mortgage payments (including $8,000 in interest and $7,000 in principal), your taxable income would be based on the $12,000 minus the $8,000 interest—not the full $15,000 payment.

Key Takeaways

  • Only mortgage interest is tax-deductible; principal payments are not, even though both are part of your monthly payment.
  • You report rental income on Schedule E (Form 1040) and deduct operating expenses including property taxes, insurance, repairs, utilities, and depreciation.
  • Depreciation is a major deduction that reduces taxable income without requiring an out-of-pocket expense, but it creates a tax liability when you sell the property.
  • If your deductible expenses exceed rental income in a year, you may be able to carry forward the loss to future years, depending on your income level and how actively you manage the property.
  • Keeping detailed records of all mortgage payments, repairs, and operating costs is essential because the IRS requires documentation to support deductions.

Which parts of your mortgage payment are deductible

Your mortgage statement should break down each payment into principal and interest. The interest portion is deductible as a rental expense. The principal portion is not—it represents your growing equity in the property and is treated as a personal investment, not a business cost.

Early in the mortgage, most of your payment goes toward interest, so your deduction is larger. As years pass and you pay down principal, the interest portion shrinks and your deductible amount decreases. By the end of a 30-year mortgage, nearly all of each payment is principal and very little is deductible interest.

If you took out a home equity line of credit or a second mortgage on the rental property, interest on that debt is also deductible if the borrowed money was used for property improvements or repairs. Interest on borrowed money used for other purposes is not deductible.

Operating expenses you can deduct alongside mortgage interest

Beyond mortgage interest, you deduct the actual costs of operating the rental property. These include property taxes, homeowners insurance, liability insurance, repairs (fixing a broken window or patching a roof), maintenance (regular upkeep), utilities if you pay them, property management fees, advertising to find tenants, and legal fees related to the rental.

The line between a repair (deductible) and an improvement (not when ready deductible) matters. A repair restores the property to its existing condition—replacing a broken door, repainting a wall, fixing plumbing. An improvement adds value or extends the life of the property—a new roof, new flooring, a deck addition. Improvements are deducted over time through depreciation rather than all at once.

You can also deduct a portion of utilities, internet, phone, and office supplies if you use part of your home as a dedicated rental office. You calculate this using the square footage of the office divided by the total square footage of your home.

How depreciation works and why it matters later

Depreciation is a deduction that reduces your taxable rental income without requiring you to spend money in that year. The IRS assumes that buildings (not land) lose value over time due to wear and tear. You deduct a portion of the building's cost each year for 27.5 years if it is a residential rental property.

To calculate depreciation, you need to know the cost basis of the building—the purchase price plus the cost of any improvements, minus the value of the land. A professional appraiser or your purchase documents can help you separate building value from land value. Once you have the building cost, you divide it by 27.5 to get your annual depreciation deduction.

Depreciation is powerful because it reduces your taxable income without cash leaving your pocket. However, when you sell the property, the IRS recaptures the depreciation you claimed and taxes it at a higher rate (25% rather than your ordinary income rate). This is called depreciation recapture. Understanding this trade-off—lower taxes now, higher taxes when you sell—is important for long-term planning.

Reporting rental income and expenses on your tax return

You report all rental income and expenses on Schedule E (Form 1040), which is filed with your federal tax return. Schedule E has separate sections for each property you own. You list total rental income received, then subtract all deductible expenses to arrive at net rental income or loss.

The IRS requires you to keep records supporting every deduction. This means receipts, invoices, bank statements, mortgage statements showing interest paid, property tax bills, and insurance policies. If you are audited, you must be able to show that expenses were ordinary and necessary for operating the rental property.

Some landlords use accounting software or hire a tax professional to track expenses throughout the year. Others use a spreadsheet. The method matters less than consistency and completeness. Whatever system you choose, start it before the year ends so you do not scramble to reconstruct records in April.

What happens if expenses exceed rental income

In some years, your deductible expenses (including depreciation) may exceed the rent you collected. This creates a rental loss. You cannot straightforward deduct this loss from your other income—the IRS has rules about when and how much rental loss you can use.

If you actively manage the rental property (you make decisions about repairs, tenant selection, and rent amounts), you may be able to deduct up to $25,000 of rental losses against your other income in a single year, provided your modified adjusted gross income is below $100,000. This deduction phases out as your income rises above $100,000 and disappears entirely at $150,000 or higher. If you do not actively manage the property or your income exceeds these thresholds, unused losses carry forward to future years when you have rental income or when you sell the property.

Passive activity loss rules are complex and depend on your specific situation. A tax professional can tell you whether you may have access to for the $25,000 deduction and how to handle losses that exceed it.

State and local taxes on rental income

In addition to federal income tax, you may owe state income tax on rental income. Some states tax rental income at the same rate as wages; others have different rates or exemptions. A few states have no income tax at all. Your state tax return typically mirrors your federal Schedule E, so the income and expenses you report to the IRS are the same ones you report to your state.

You may also owe local property taxes, which are deductible as a rental expense on your federal return. Some cities and counties impose additional rental income taxes or licensing fees on landlords. Check with your local assessor's office or a local tax professional to understand what applies in your area.

Frequently Asked Questions

Do I have to report rental income if I only rented the property for part of the year?

Yes. You report income for the months the property was rented and deduct expenses for those same months. If you rented it for six months and left it vacant for six months, you report six months of rental income and six months of operating expenses (property taxes and insurance still explore during vacancy, but utilities and maintenance may not).

Can I deduct the cost of a new roof or major repair?

It depends whether it is a repair or an improvement. Replacing a few shingles is a repair and is fully deductible. Replacing the entire roof is an improvement and must be depreciated over 15 to 27.5 years depending on the component. When in doubt, consult a tax professional or your accountant.

What if I have a loss on the rental property—can I use it to reduce my other income?

You may be able to, depending on your income level and whether you actively manage the property. If you may have access to, you can deduct up to $25,000 of rental losses against wages, investment income, or other sources. Losses above that amount carry forward to future years. Your tax situation determines whether you may have access to.

Do I need to report the principal portion of my mortgage payment?

No. Principal is not deductible and is not reported as an expense on your tax return. Only the interest portion is deductible. Your mortgage statement separates the two, so you can easily identify which amount to claim.

How do I know what the building value is for depreciation purposes?

You can use the purchase price of the property minus the assessed land value (from your property tax bill or county assessor), or hire an appraiser to separate building from land. The IRS does not require a formal appraisal, but your estimate should be reasonable and defensible if audited.