A rental property can generate “taxable losses” that can be used to reduce your normal salary income, hence the federal income taxes you pay. It’s difficult for most people to understand how taxes work, and even more confusing once we get into the realm of rental properties and taxes. Note that understanding how taxes impact personal residences are a completely different topic, as those are governed by totally separate tax codes and go elsewhere on your 1040 form.

Below are some of the basics to understanding rental properties and federal income taxes.

Often I hear people saying that they want to buy some real estate to save money on income taxes. However, depending on your tax situation, owning real estate might not save you a dime on taxes. It wholly depends on your specific tax picture and the IRS rules about Passive Activity Loss Limitations.

First and foremost you should never make real estate investment decisions based solely on tax considerations. The first order of business is do your due diligence and determine if an investment makes sense based on cash flows, cash on cash returns, renovation costs, rental income, financing, and the risk of any particular property. Once you believe it makes sense in every other sense, then you can contemplate the tax effects.

Important note: Always have a CPA, attorney or licensed tax professional guide you through your individual tax picture — this article is an illustration of one scenario but your scenario can be very different based on your financial picture.

To better understand, let’s first quickly discuss the IRS 1040 form.

The 1040 form you fill out each year does two things:

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