Rental & Royalty Income Basics

Rental and royalty income are reported on Schedule E (Form 1040), Part I. These income types represent important passive income sources that come with unique rules for timing, deductions, and loss limitations. Mastering these rules is critical for EA exam success.

What Counts as Rental Income?

Rental income includes all payments you receive for the use or occupation of property. The IRS requires you to report rental income in the year you receive it, regardless of when it was earned:

Example: A landlord receives a $3,000 security deposit in December 2024. In March 2025, the tenant moves out, and the landlord keeps $800 for carpet damage. The $800 is rental income for 2025 (the year it was kept), not 2024.

When Does Rental Activity Begin?

Rental income and expenses begin when the property is placed in service—meaning when it is first available for rent, not when the first tenant moves in. If you advertise a property for rent on September 1 but do not find a tenant until November 1, your rental activity began September 1.

Fair market rent requirement: When renting to related parties (family members), you must charge fair market rent. If rent is below market value, the property may be classified as personal use, affecting deductions and depreciation.

Deductible Rental Expenses

You can deduct ordinary and necessary expenses for managing, conserving, and maintaining rental property. These expenses reduce your rental income on Schedule E, Part I:

Repairs vs. Improvements: A Critical Distinction

The IRS draws a clear line between repairs (currently deductible) and improvements (must be capitalized and depreciated):

Repairs maintain the property in ordinary efficient operating condition:

• Patching walls and fixing leaks
• Replacing broken windows
• Repainting rooms
• Fixing plumbing or electrical issues

Improvements add value, extend useful life, or adapt property to new use:

• Adding a new room or deck
• Replacing the entire roof
• Installing new HVAC system
• Upgrading the electrical system

The 30% rule: If you replace 30% or more of a major building system (HVAC, plumbing, electrical, roofing), it is generally treated as a capital improvement even if you consider it a repair.

De minimis safe harbor: Landlords can immediately expense items costing $2,500 or less per item (per invoice) under the de minimis safe harbor election, regardless of whether the expenditure is technically a repair or improvement.

Depreciation Rules

Depreciation allows landlords to recover the cost of rental buildings (not land) over time. The IRS requires the Modified Accelerated Cost Recovery System (MACRS) with straight-line depreciation:

Mid-month convention: Regardless of the actual date placed in service, treat property as placed in service at the middle of the month. A property placed in service on January 1 gets 11.5 months of depreciation for the first year; a property placed in service on January 31 also gets 11.5 months.

Land is never depreciable. You must allocate your purchase price between land and building (often using the property tax assessment ratio).

Personal Use Rules: Vacation Home Limitations

When you use rental property for personal purposes, special vacation home rules may apply, limiting your deductions. The key test is whether personal use exceeds the greater of 14 days or 10% of rental days.

Three property classifications:

Example: You rent a beach house for 200 days and use it personally for 25 days. The 10% threshold is 20 days (10% x 200). Since personal use (25 days) exceeds 20 days, vacation home rules apply, and deductions are limited to rental income.

What counts as personal use?

• Days you or family members use the property
• Days rented to others at below fair market rent
• Days donated to charity auctions
• Days the property sits unused do NOT count as personal use

What does NOT count as personal use?

• Days spent substantially full-time on repairs and maintenance

Passive Activity Loss Rules

Rental activities are generally treated as passive activities under IRC Section 469. This means:

• Rental losses can only offset passive income (not wages, interest, or dividends)
• Unused passive losses carry forward indefinitely
• Passive losses are fully deductible in the year you dispose of the entire interest

The $25,000 Special Allowance

An important exception exists for taxpayers who actively participate in rental real estate activities:

Active participation (not material participation) requires:

• Owning at least 10% of the rental activity
• Making management decisions (approving tenants, repairs, lease terms)
• May use a property manager and still qualify

Example: A taxpayer with $120,000 MAGI and $31,000 rental loss:

• Phase-out: ($120,000 - $100,000) x 50% = $10,000 reduction
• Allowable deduction: $25,000 - $10,000 = $15,000
• Carryforward: $31,000 - $15,000 = $16,000 suspended passive loss

Real Estate Professional Exception

Taxpayers who qualify as real estate professionals can treat rental activities as non-passive, allowing unlimited loss deductions against ordinary income. Requirements:

Real property trades or businesses include: development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

Election to aggregate: Real estate professionals can elect to treat all rental activities as a single activity for the material participation test (must file statement with original return).

Royalty Income

Royalty income represents payments for the use of property or rights. Report royalties on Schedule E, Part I, just like rental income.

Depletion deduction: Owners of oil, gas, or mineral royalties can claim depletion—either cost depletion or percentage depletion (whichever is greater). The standard percentage depletion rate for oil and gas is 15% of gross income.

Percentage depletion limitations:

• Cannot exceed 100% of net income from the property
• Total percentage depletion cannot exceed 65% of taxable income from all sources

Form 1099-MISC Reporting

Payers report rental and royalty payments on Form 1099-MISC:

Note: Box 1 includes rents for office space, equipment, machinery, farmland, and pasture. Surface royalties are reported in Box 1, not Box 2. Oil and gas working interest income goes to Form 1099-NEC, not 1099-MISC.

On the EA Exam

Expect questions on:

• Distinguishing repairs (deductible) from improvements (capitalize)
• Calculating the $25,000 passive loss allowance with MAGI phase-out
• Applying the 14-day/10% vacation home rules
• Knowing depreciation periods (27.5 years residential, 39 years commercial)
• Understanding when rental income is reportable (advance rent, security deposits)
• Real estate professional qualification requirements

Exam tip: Remember that the $25,000 allowance requires "active participation" (management decisions), while the real estate professional exception requires "material participation" (750+ hours)—these are different standards.