How Is Rental Income Taxed in California: Deductions and Depreciation

Rental income from California property is taxed twice: once by the IRS on your federal return, and again by California, which treats it as ordinary income at rates from 1% to 12.3%. If your total taxable income tops $1 million, an additional 1% Mental Health Services Tax pushes the state’s top effective rate to 13.3%.¹ Higher-income landlords may also owe a federal 3.8% Net Investment Income Tax on top of that. Between deductions, depreciation, passive loss limits, and California’s refusal to follow several federal breaks, the gap between the rent you collect and the tax you actually owe has more moving parts than most owners expect.

What You Have to Report as Rental Income

Rental income is more than the monthly check. Rent paid in advance is taxable in the year you receive it, even if it covers a future period. A tenant who hands you six months upfront in December generates six months of income in that same tax year.²

Lease cancellation fees follow the same rule. If a tenant pays to break the lease early, that payment is rental income in the year you keep it. When a tenant provides services instead of rent, such as repainting the unit in exchange for skipping a month, you report the fair market value of the work as income, and can then deduct that same amount as a rental expense.²

Security deposits are not taxable when collected, as long as you intend to return them. Any portion you keep for damage or unpaid rent becomes income in the year you keep it. If a deposit is labeled from the start as the final month’s rent, it counts as advance rent and is taxed on receipt.³

One narrow exception: if you rent out a residence for fewer than 15 days during the year, you don’t have to report the income at all. You also can’t deduct any rental expenses tied to those days.⁴

Deductions That Lower Your Rental Tax Bill

You can deduct the ordinary and necessary costs of managing and maintaining the property. The largest items are usually mortgage interest, property taxes, and insurance premiums for coverage such as fire, theft, or landlord liability.²

Day-to-day upkeep also counts: landscaping, cleaning, routine plumbing or appliance fixes. So do property management fees, legal and accounting costs tied to the rental, advertising for vacancies, utilities you pay for tenants, and travel when the primary purpose of the trip is managing the property.²

Repairs Versus Improvements

This is where audits tend to focus. A repair keeps the property in its current working condition. Fixing a leaky faucet, patching drywall, replacing a broken window. Repairs are deductible in full in the year you pay for them.

An improvement is different. The IRS treats an expense as an improvement if it makes the property better than it was, restores it after significant damage, or adapts it to a new use. Replacing an entire roof, adding a deck, or converting a garage into a rental unit all qualify. Improvements have to be capitalized and recovered through depreciation over time.²

Depreciation, and Where California Splits From the IRS

Depreciation lets you deduct part of the building’s cost every year to account for wear and tear, even though no cash leaves your account. Residential rental property has a recovery period of 27.5 years, so you divide the building’s cost basis by 27.5 for your annual deduction. Land can’t be depreciated, only the building and its improvements.⁵

California does not follow federal bonus depreciation. At the federal level you may be able to immediately deduct a percentage of the cost of certain qualifying assets in the year they’re placed in service. California ignores that entirely. On your state return you have to add back any federal bonus depreciation and use straight-line depreciation instead, which slows cost recovery and raises your state tax in the early years.

The same split applies to Section 179 expensing, which lets you write off certain tangible property like appliances and equipment used in the rental. The federal Section 179 limit for 2026 is $2,560,000. California caps it at $25,000, with a phase-out that starts at $200,000 of qualifying property placed in service during the year.⁶ In practice, California landlords end up keeping two depreciation schedules, one federal and one state.

Passive Loss Limits

Rental real estate is a passive activity by default. Losses can’t freely offset your wages, business income, or other non-passive earnings. Unused passive losses carry forward until you have passive income to absorb them or you sell the property.

There is a meaningful exception. If you actively participate in managing the rental, meaning you approve tenants, set rental terms, and authorize repairs, you can deduct up to $25,000 of rental losses against ordinary income each year. That allowance phases out once your modified adjusted gross income tops $100,000, shrinking by $1 for every $2 of income above the threshold. By $150,000 of MAGI, it’s gone.⁷

You need at least a 10% ownership interest to qualify for active participation. If you’re married filing separately and lived with your spouse at any point during the year, the allowance isn’t available.⁸

Landlords who qualify as real estate professionals can treat rental income and losses as non-passive and deduct unlimited rental losses against any type of income. The bar is high: more than 750 hours per year in real property trades or businesses, and more than half of your total working hours in real estate activities. For couples filing jointly, only one spouse needs to meet both tests, and hours can’t be combined between spouses.⁹ Most people with a full-time job outside real estate won’t clear it.

The 20% QBI Deduction, Federal Only

The Section 199A deduction lets eligible landlords deduct up to 20% of qualified business income from a rental activity, cutting the effective federal rate on that income. Originally set to expire after 2025, it was made permanent by the One Big Beautiful Bill Act. A safe harbor is available for rental enterprises that meet certain recordkeeping and hour requirements. Even without the safe harbor, a rental that rises to the level of a trade or business under general tax principles can qualify.¹⁰

California does not conform to Section 199A. The QBI deduction gives you nothing on your California return, so while it reduces your federal bill, your state calculation ignores it. This is one of several places where your federal and state taxable incomes will diverge.¹¹

The 3.8% Net Investment Income Tax

A federal surtax that catches many landlords by surprise is the 3.8% Net Investment Income Tax. Rental income, including net gains from selling rental property, counts as net investment income. The tax kicks in when your MAGI exceeds $200,000 for single filers, $250,000 for married filing jointly, or $125,000 for married filing separately. It applies to the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.¹²

On the other side, rental income is generally exempt from self-employment tax. That’s a real benefit compared with running an active business, and it applies to most landlords who simply collect rent and hire out management tasks.

Taxes When You Sell

Sell a rental property for more than its adjusted cost basis, and the gain is taxed at two different federal rates. The portion attributable to depreciation you claimed is taxed as unrecaptured Section 1250 gain at a maximum federal rate of 25%. Any remaining gain, if you held the property more than a year, is taxed at long-term capital gains rates. California treats the entire gain as ordinary income. The state doesn’t offer preferential rates for capital gains.

Depreciation recapture is mandatory. Even if you never claimed depreciation deductions during ownership, the IRS taxes the recapture as if you had. There is no opting out.

Deferring Gains With a 1031 Exchange

A like-kind exchange under Section 1031 lets you defer both capital gains tax and depreciation recapture by rolling the proceeds into another qualifying investment property. The timelines are strict. You have 45 days from the sale to identify potential replacement properties in writing, and the exchange must close within 180 days of the sale or by the due date (with extensions) of your tax return for that year, whichever comes first.¹³ Miss either deadline and the whole gain is taxable. Neither one can be extended, except for a presidentially declared disaster.

How to File in California

Rental income and expenses go on IRS Schedule E (Form 1040). You list gross income for each property, itemize deductible expenses, and enter your depreciation. The net income or loss flows into your federal return.¹⁴

For California, the net rental figure from your federal return carries over to Form 540 after any required adjustments for items where the state doesn’t conform: bonus depreciation, Section 179 differences, the QBI deduction. If you expect to owe $500 or more in state tax ($250 if married or in a registered domestic partnership filing separately), you have to make estimated payments to the Franchise Tax Board using Form 540-ES. California splits those payments unevenly: 30% for the first installment, 40% for the second, nothing for the third, and 30% for the fourth.¹⁵

If You Live Outside California

Rental income from California property is California-source income even if you live in another state. You file Form 540NR instead of Form 540. Non-residents have a filing requirement when gross income from California sources exceeds certain thresholds. For a single filer under 65 with no dependents, that threshold is $22,941 for the 2025 tax year.¹⁶ Modest rental income can trigger the filing obligation, and the same estimated payment rules apply. Non-residents are also subject to California’s withholding rules on real estate sales, where the buyer or intermediary may have to withhold a portion of the proceeds for the state.

1
Franchise Tax Board. 2025 California Tax Rate Schedules
2
Internal Revenue Service. Publication 527 (2025), Residential Rental Property
3
Internal Revenue Service. Topic No. 414, Rental Income and Expenses
4
Internal Revenue Service. Topic No. 415, Renting Residential and Vacation Property
5
Internal Revenue Service. Publication 946 (2025), How To Depreciate Property
6
Franchise Tax Board. 2025 Instructions for Form FTB 3885
7
Office of the Law Revision Counsel. 26 US Code 469 – Passive Activity Losses and Credits Limited
8
Internal Revenue Service. Instructions for Form 8582
9
Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
10
Internal Revenue Service. Qualified Business Income Deduction
11
Franchise Tax Board. Partners Instructions for Schedule K-1 565
12
Internal Revenue Service. Net Investment Income Tax
13
Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
14
Internal Revenue Service. About Schedule E (Form 1040), Supplemental Income and Loss
15
Franchise Tax Board. 2025 Form 540 Booklet Information
16
Franchise Tax Board. 2025 540NR Booklet