Learn how rental and royalty income is reported on tax forms, which deductions apply, and how tax treatment varies based on income type and activity level.
Earning income from rental properties or royalties comes with specific tax obligations that must be reported correctly to avoid penalties. The IRS requires individuals to report these earnings accurately, but the process can be complex due to different forms, deductions, and classifications. Properly accounting for this income ensures compliance while maximizing allowable deductions.
Taxpayers must understand which forms apply, what expenses can be deducted, and how the IRS treats rental and royalty income differently. Proper reporting also determines whether the income is classified as passive or nonpassive, which affects taxation.
Rental and royalty income both involve payments for the use of an asset but are treated differently for tax purposes. Rental income comes from leasing real estate, such as homes, commercial buildings, or land. The owner retains control while allowing tenants to occupy the space in exchange for periodic payments. These payments, typically received monthly, are subject to tax rules that account for depreciation, maintenance costs, and other property-related expenses.
Royalty income arises from granting others the right to use intangible assets, such as patents, copyrights, trademarks, or natural resources. Instead of fixed payments, royalties are often structured as a percentage of revenue generated from the asset’s use. An author licensing a book to a publisher earns royalties based on sales, while a landowner leasing mineral rights to an oil company earns royalties based on extracted resources.
The IRS classifies rental income as passive unless the taxpayer qualifies as a real estate professional, which affects how losses are deducted. Royalty income is generally nonpassive, particularly when it comes from self-created intellectual property, meaning it may be subject to self-employment tax if the taxpayer actively manages or promotes the asset.
Reporting rental and royalty income requires the correct tax forms. Rental income is typically reported on Schedule E (Form 1040), detailing earnings, depreciation, and deductible costs. If a taxpayer owns multiple rental properties, each must be listed separately.
If a taxpayer actively manages rental properties and provides substantial services beyond basic maintenance—such as daily cleaning or concierge assistance—the IRS may classify the activity as a business rather than passive investment income. In such cases, income is reported on Schedule C (Form 1040), which is used for sole proprietors. Schedule C filers may be subject to self-employment tax, whereas Schedule E filers are not.
Royalty income is also reported on Schedule E when it comes from investments, such as payments from oil, gas, or mineral rights, or intellectual property the taxpayer did not create. However, royalties from self-created works—such as books, music, or patents—are reported on Schedule C because they are considered self-employment earnings. This classification affects tax liability, as self-employment income is subject to an additional 15.3% tax for Social Security and Medicare.
Failing to report rental or royalty income correctly can lead to IRS penalties, including accuracy-related fines of 20% of the underpaid tax. Underreporting income by more than 25% of gross receipts may trigger an extended six-year statute of limitations for IRS audits instead of the standard three years. Taxpayers receiving payments from third parties, such as property management companies or publishers, may also receive Form 1099-MISC or Form 1099-NEC, which the IRS uses to verify reported income. If these forms are issued, the total income must match the amounts reported on the tax return to avoid discrepancies that could prompt an audit.
Rental property owners can deduct many expenses to lower taxable income. The IRS allows deductions for ordinary and necessary expenses related to operating, maintaining, and managing rental properties. These include property repairs, insurance premiums, and professional services.
One of the most significant deductions is depreciation, which allows property owners to recover the cost of residential rental buildings over 27.5 years or commercial buildings over 39 years. Land improvements, such as driveways and fences, must be depreciated separately, while land itself is not depreciable. Incorrect depreciation calculations can lead to IRS adjustments and penalties.
Mortgage interest on loans used to acquire or improve rental properties is fully deductible. This also applies to interest on credit lines used for property-related expenses. However, interest on personal loans or credit card debt not directly tied to the rental business cannot be deducted. Landlords should maintain clear records to distinguish business-related borrowing from personal expenses.
Repairs and maintenance costs are deductible in the year they are incurred, but improvements that increase the property’s value—such as adding a new roof or upgrading plumbing—must be capitalized and depreciated. Misclassifying improvements as repairs can lead to audit issues.
Legal and professional fees related to rental activities, including payments to attorneys, accountants, and property managers, are deductible. This also includes fees for preparing tax returns specific to the rental business. Advertising expenses for attracting tenants, such as online listings or signage, qualify as deductible marketing costs. Travel expenses related to property management, including mileage for visiting rental units, can also be deducted, though personal travel cannot be mixed with business deductions.
Royalty income earners can deduct expenses directly related to generating or protecting royalty revenue. For individuals receiving royalties from intellectual property, common deductions include copyright or patent registration fees, legal costs for contract negotiations, and expenses incurred in defending intellectual property rights.
For those earning royalties from natural resources, depletion deductions allow taxpayers to recover the cost of resource extraction. Cost depletion calculates the remaining recoverable reserves and deducts a proportionate amount each year, while percentage depletion allows a deduction based on a fixed percentage of gross revenue. For oil and gas royalties, percentage depletion is generally capped at 15% of gross income, though small producers may qualify for higher rates.
Marketing and promotion expenses are deductible for royalty income earners. Authors and musicians can deduct costs related to book tours, promotional events, website maintenance, and advertising campaigns. Licensing fees paid to distribute or broadcast creative works are deductible if necessary for generating royalty income. Travel costs for contract negotiations or industry events can also be deducted if they are business-related.
The IRS categorizes rental and royalty income as passive or nonpassive, which affects how losses can be deducted and whether income is subject to additional taxes.
Rental income is generally passive unless the taxpayer qualifies as a real estate professional. To qualify, the individual must spend more than 750 hours per year in real estate activities and have more than half of their total working hours dedicated to the industry. If these conditions are met, rental losses can be deducted against other income without passive activity limitations. Otherwise, passive losses can only offset passive income, though taxpayers with an adjusted gross income (AGI) under $150,000 may qualify for a $25,000 special allowance.
Royalty income is often nonpassive, particularly when it results from self-created intellectual property. If a taxpayer actively manages or promotes their work—such as an author handling book sales or a musician licensing recordings—the income is considered earned and may be subject to self-employment tax. However, royalties from investments, such as oil and gas leases or inherited intellectual property, are generally passive, meaning they are not subject to self-employment tax but are also subject to passive loss limitations.
Some taxpayers earn both rental and royalty income, requiring careful tax planning. If rental income is passive but royalty income is nonpassive, passive rental losses cannot offset nonpassive royalties unless special exceptions apply. Tracking each income stream separately is necessary to avoid miscalculations that could trigger an IRS audit.
For landowners receiving royalties from natural resource leases, rental income from leasing the land is reported separately from royalties generated from resource extraction. Some expenses, such as property taxes and legal fees related to lease agreements, may be allocated between the two income sources. However, deductions must be allocated proportionally based on the income generated from each activity to comply with IRS guidelines.