Rental property is one of the few investments where the bookkeeping directly changes the tax bill. Miss the depreciation, mix two properties in one account, or let a loss get trapped by the passive-activity rules, and you’ve paid tax you never owed. Here’s how we set up the books for real estate investors, what’s actually deductible, and the question we get most often: whether putting the property in an LLC changes anything.
This is general information, not individual tax advice — the right treatment depends on your specific situation.
One Set of Books per Property
Every property needs its own income and expense tracking, even if you own all of them personally. The IRS wants rental results reported property by property on Schedule E, lenders want property-level statements when you refinance, and you need to know which door is actually making money. In practice that means a dedicated bank account (or at minimum a class or location tag in QuickBooks or Xero) for each property, with rent, security deposits, mortgage payments, repairs and management fees coded to it.
Two things trip up new investors. Security deposits are not income when you receive them, if you intend to return them; they become income only when you keep part of one. And the mortgage payment is not an expense. Only the interest portion is deductible; the principal reduces the loan on the balance sheet. Your amortization schedule is a bookkeeping document, not just a lender document.
What You Can Deduct (and the Land Trap)
Ordinary and necessary rental expenses are deductible in the year paid: mortgage interest, property taxes, insurance, utilities you cover, management fees, advertising, legal and accounting fees, HOA dues, and travel to the property for management purposes. Small purchases of tangible items can be expensed outright under the de minimis safe harbor if each item or invoice is $2,500 or less and you make the annual election on your return.
The biggest deduction is the one that never shows up on a bank statement: depreciation. A residential rental building is written off on a straight line over 27.5 years from the date it’s placed in service, and commercial buildings over 39 years. The catch is that land is never depreciable. You have to split your purchase price between building and land, usually using the assessor’s ratio or an appraisal, and document how you did it. Skip the split and you’ve either overstated the deduction (an audit problem) or understated it (a money problem).
Repairs vs. Improvements, and the 2026 Bonus Depreciation Window
A repair keeps the property in its ordinary operating condition and is deducted now: patching a roof, fixing a furnace, repainting a unit. An improvement betters the property, restores it, or adapts it to a new use, and must be capitalized and depreciated: a new roof, a replaced HVAC system, a finished basement. The line is fact-specific, and the books should record enough description on each invoice to defend the call later.
Capitalized costs aren’t all stuck on the 27.5-year schedule. Appliances, carpeting, certain fixtures and land improvements have shorter recovery periods, and the One, Big, Beautiful Bill Act restored 100% bonus depreciation for qualifying property acquired and placed in service after January 19, 2025. For a larger purchase (see Section 179 and bonus depreciation for the general rules), a cost segregation study can reclassify parts of the building into those shorter-life categories and front-load a meaningful share of the deduction into year one. Whether that’s worth doing depends on your purchase price, your other income and the passive-loss rules below.
The Passive-Loss Rules That Trap New Investors
Thanks to depreciation, a rental can show a tax loss while producing positive cash flow. The question is whether that loss can offset your salary or business income. By default, rental losses are passive and can only offset passive income; the excess carries forward on Form 8582 until you have passive income or sell the property.
Two exceptions matter. First, if you actively participate (approve tenants, set rents, authorize repairs) you can deduct up to $25,000 of rental losses against other income. That allowance shrinks by 50 cents for every dollar your modified adjusted gross income exceeds $100,000, and disappears entirely at $150,000. Second, if you qualify as a real estate professional, which requires more than 750 hours a year in real property businesses in which you materially participate and more than half of all your working hours in those businesses, your rental losses can become non-passive. Both exceptions live or die on records: a contemporaneous log of hours and activities, kept during the year, not reconstructed in April.
Does Holding Property Through an LLC or Partnership Change Your Tax Exposure?
This is the question behind most “should I put it in an LLC” conversations, and the honest answer is: the LLC changes your liability exposure, not your federal income tax — unless you add partners.
Single-member LLC. For federal tax purposes a one-owner LLC is disregarded. The rental is reported on your personal Schedule E exactly as if you held the deed yourself (see our guide to single-member LLC taxes). Same depreciation, same deductions, same passive-loss rules, same rates. What you gain is a liability shield between the property and your other assets, provided you actually run it as a separate entity with its own bank account and no commingling.
Multi-member LLC or partnership. Add a second owner and the entity files its own return, Form 1065, and issues each partner a Schedule K-1 (our partnership taxes and K-1 primer walks through the mechanics). The income and deductions still flow to the owners’ personal returns, but three things change. The books now have to track each partner’s capital account and share of the mortgage, because those drive how much loss each partner can deduct. The partnership agreement, not the deed, controls how income, depreciation and sale proceeds are split. And the passive-loss analysis gets harder: a limited partner generally isn’t treated as actively participating for the $25,000 allowance, and anyone claiming it needs at least a 10% interest in the activity. If the entity itself isn’t careful, partners can find losses trapped that they assumed they could use.
The qualified business income deduction. The 20% QBI deduction was made permanent by the 2025 tax law, and rental real estate can qualify for it when the activity rises to the level of a trade or business. The IRS safe harbor requires separate books for each rental enterprise, 250 or more hours of rental services a year, and contemporaneous time records. Property held directly or through a disregarded entity can use the safe harbor; a partnership can too, with the statement attached at the entity level. Triple-net leases and properties you also use as a residence are excluded.
The non-tax exposures people forget. Deeding a mortgaged property into an LLC can trigger the loan’s due-on-sale clause. The federal Garn–St Germain Act protects certain transfers, such as to a revocable living trust, but it does not cover transfers to an LLC, so get the lender’s written consent first. Your insurance policy needs to name the LLC as the insured. Your state may charge an annual LLC report fee and, in some cases, a transfer or recording tax on the deed. None of these are reasons not to use an LLC; they are reasons to plan the transfer rather than just file one.
What doesn’t change. Rental income is generally not subject to self-employment tax whether or not it sits in an LLC. Electing to have the LLC taxed as an S corporation almost never helps a long-term rental and can create real problems when you later refinance or distribute the property. If someone is pitching an entity change as a tax strategy for a buy-and-hold rental, ask them to show you the number.
Short-Term Rentals Are a Different Animal
If you rent by the night and provide substantial services (daily cleaning, meals, concierge-style help), the IRS may treat the activity as a business rather than a rental. That moves it from Schedule E to Schedule C, where the income is subject to self-employment tax, and it changes how the passive-loss rules apply. The books for a short-term rental also need to capture platform fees, lodging and occupancy taxes collected, and personal-use days, which limit your deductions if you stay there yourself.
How VarStan Helps
VarStan’s CPA-led team sets up property-level books, builds and documents the building-versus-land split and depreciation schedule, keeps the partner capital accounts straight on a multi-owner deal, and tracks the hours and records that make the passive-loss and QBI exceptions hold up. If you’re buying your first rental, adding a partner, or moving a property into an LLC, talk to us before the closing. The decisions that save the most tax are the ones made before the deed is recorded.
Related reading: The SALT Cap Workaround: How the State PTET Election Works and Accountable Plans: Reimbursing Owners & Employees Tax-Free.