Mortgage Interest Tax Deduction on Rental Property
As pointed out by reader Jason, another consideration when evaluating the cashflow potential for a rental property is whether you can deduct the mortgage interest on your taxes. To see what the rules are, I always like to start directly at the source, which meant a stroll through those fun IRS publications.
First, I started with IRS Pub. 936, Home Mortgage Interest Deduction. There is the basic definition of a “qualified” home:
For you to take a home mortgage interest deduction, your debt must be secured by a qualified home. This means your main home or your second home. A home includes a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.
Then there is the question of how much you live in the second home:
Second home rented out. If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home. For information on residential rental property, see Publication 527.
If you live in it enough, it is treated as a “vacation” property and you can deduct the mortgage interest. In general, you are limited to the interest paid on the qualified loan limit of $1,100,000 for “home acquisition debt” combined for both first and second houses.
However, for a full-time rental, we are led to IRS Pub. 527, Residential Rental Property, which states:
Generally, the expenses of renting your property, such as maintenance, insurance, taxes, and interest, can be deducted from your rental income.
Interest expense. You can deduct mortgage interest you pay on your rental property. Chapter 4 of Publication 535 explains mortgage interest in detail.
Okay, now I’m off to IRS Pub. 535, Business Expenses, specifically the section on Interest.
You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all the following requirements.
* You are legally liable for that debt.
* Both you and the lender intend that the debt be repaid.
* You and the lender have a true debtor-creditor relationship.
There are special rules for the capitalization of interest if you actually build the home yourself.
Summary
I am not a tax professional, but from reading the above publications, it appears that mortgage interest on a 100% rental home is not tax-deductible as an itemized deduction as your primary house may be.
However, chances are that it is an eligible expense that can offset your rental income and still reduce your tax burden in a similar manner. If you made $10,000 in annual rental income but paid $8,000 in mortgage interest, and ignoring other factors like depreciation, you’d only owe income taxes on the difference of $2,000. (Dealing with writing-off rental losses is for another post.) The amount paid that lowers your loan principal is not an eligible expense.
As long as you have adequate rental income, this would make the mortgage interest as an expense better than just an itemized deduction, since everyone gets the standard deduction. For 2009, the standard deduction is $5,700 for single filers, and $11,400 for married filing jointly. Only total itemized deductions above that amount would provide added savings.
Find more in Real Estate, Taxes | 6/22/09, 5:07pm | Trackback
June 22nd, 2009 at 6:41 pm
Mortgage interest expense is deductable on Schedule E. It can offset income if you are a passive investor. If you are an active investor you may be able to offest up to $25,000 in loses against other income.
June 22nd, 2009 at 7:34 pm
Counting mortgage interest against income seems to be far better than counting it as a deduction. The posts insinuates that the deduction is better. Maybe I read it wrong…
June 22nd, 2009 at 10:08 pm
More posts like this please!
I’m looking to move and rent out my current residence. I’m trying to determine if the income is worth the effort, and it is really hard to tell.
In addition to the mortgage interest, I believe you can write off the depreciation of the house as well over 27.5 years. So if you have a 275K house, you can write off 10K each year to depreciation. (Again, I’m not sure about all this as I’m still figuring it out myself.)
It appears the combination of mortgage interest expenses + depreciation + repairs/maintenance would almost always insure your property had a loss on paper even though you would potentially be making money on rent.
If anyone has any experience with this, I’d love to hear about it… Not sure if I’d just be better off buying a REIT to get real estate exposure and selling my house and not dealing with the hassles of being a landlord.
June 23rd, 2009 at 12:30 am
Added the last paragraph:
“As long as you have adequate rental income, this would make the mortgage interest as an expense better than just an itemized deduction, since everyone gets the standard deduction. For 2009, the standard deduction is $5,700 for single, and $11,400 for married filing jointly. Only deductions above that amount would provide added savings.”
The problem comes when you are trying to make losses offset your income. There is a $25,000 limit as long as you are a passive investor (don’t spend majority of time as real estate pro). But then there are income phase-outs when your adjusted gross income is over $150k. But THEN, you can carry the losses over for future income.
Like I said, enough for another post!
Depreciation is also tricky since it seems you’d get hit with the taxes anyway if you eventually sell the house. Does improve cashflow though.
June 23rd, 2009 at 11:07 am
Is the $25K limit for passive or non-passive? What’s the technical difference?–and what are the advantages of each? I suppose this may be another post …
June 23rd, 2009 at 11:33 am
As Paul said, you deduct mortgage interest on rentals as an expense in Schedule E. All your rental expenses are in schedule E.
June 23rd, 2009 at 12:42 pm
Great info, like Maury I’ll eventually rent out my current house. I have a lot to learn before then as to the economics of being a landlord.
June 23rd, 2009 at 2:26 pm
Do not forget the depreciation, at the time when you sell this property assume there is a gain, but even if there is not, one must recapture and depreciation allowed or allowable, in other you must recapture the depreciation whether you took the expense or not! This can be huge. But don’t forget land is not depreciable, so if you own a $250,000 house and the land is worth $100,000 only $150,000 will be the amount depreciated. Oh you need a new water heater, cost must be depeciated.
BTW if you go collect the rent or go check on the property you are non passive usually best to be non passive.
There are lots of expenses in owning property like each time you go collect the rent – mileage. Course that is a good time to replace the furnace filter (lets you get in the house)
June 23rd, 2009 at 3:29 pm
I used to occupy 1/2 of the duplex I own. During that time I could deduct 50% of my mortgage interest as an itemized deduction. The other 50% was a business expense that helped offset the rent I was paid. Maury, I always showed a paper loss after depreciation was added in, and so my rental “loss” did actually come right off the top of my income. This was actually better that the 50% itemized deduction, because as Jonathan pointed out, the standard deduction nullifies a large portion of that itemization. As for the depreciation being recaptured at time of sale, that is true because it reduces your basis by the depreciated amount. However, the recapture is taxed as capital gains, and is therefore less than the income tax off the top of your bracket (depending on what bracket you’re in I suppose).
I now rent out the entire duplex. Even though I can now deduct 100% of the mortgage interest as an expense, I take in twice the rent, so my paper loss is much less. I don’t get to deduct my current rent where I live (moved for employment reasons), so it is actually much less efficient than living there (tax wise).
I suppose my point is that an owner occupied rental has some additional benefits and is quite a cheap way to live. Owning a fully rented property to me is actually more hassle than its worth financially, and I wont be doing it again any time soon. This is especially true if you cannot do almost all required maintenance yourself. I wouldn’t think this sort of investment really starts to pay off unless your heavily leveraged and own a dozen properties. Of course, higher risk, higher possible return. In my opinion, casually investing in property outside of an owner occupied situation is almost always going to return less than a balanced paper portfolio. I would have never thought this before I actually owned property, but I tend to side now with argument in the following article:
http://articles.moneycentral.m.....icher.aspx
June 23rd, 2009 at 6:12 pm
There are many ways to handle borrowing money for rental properties. For those that make above the passive loss phaseout of $150k you might be better off borrowing additional amounts from your primary residence (which can be deducts as mortgage interest for your primary residence) as a itemized deduction. While not as good as a rental expense – if you can’t take the losses, its more advantageous than permanently carrying forward rental losses.
June 24th, 2009 at 5:26 am
Does anyone know how rental interest and business expenses factor in to AMT calculations? Are those deductions ignored for AMT like your personal home mortgage interest, or are they preserved like charitable contributions? My wife and I are just under the threshold for AMT eligibility, and I’m thinking that with the additional rental income and the deductions possibly ignored by AMT calculations that we would not see any tax advantages from a rental property.
June 24th, 2009 at 6:56 am
I don’t understand the confusion here. Mortgage interest on rental property goes on schedule E along with the other expenses. It is pretty straightforward. Don’t forget the depreciation! Losses on rental property are deductible against ordinary income subject to the passive loss limit. Hire a CPA!
June 24th, 2009 at 10:50 pm
Lots of very interesting things in the post and comments. I’m a tax attorney and a real estate investor, so I feel like I’m on my home turf with this post.
Let me throw out a few thoughts I had while reading the post and comments.
First thought: Showing a gain for tax purposes is different than being cash flow positive, and both are different than my true economic gain on a property. I nearly always show a loss FOR TAX PURPOSES on every property the first few years. Generally my cash flow is close to breakeven in the beginning. My true economic gain should be higher than my cash flow because of appreciation on the property (knock on wood). Over time my gross income grows (rents rise) while my costs largely stay the same (fixed mortgage, insurance, property tax, etc.). As a result my cash flow grows and my tax loss shrinks over time.
Second thought: When I consider a property, oftentimes it’s the tax savings (from the tax loss I know I will show) that make the difference between buying or not. True some of the tax loss is due to depreciation that may be subject to recapture some day. But that’s okay, I love deferral. And if I really want to avoid the recapture altogether, I can do a 1030 exchange (actually further deferral), or sell the property in a year when I have low income and won’t pay much tax (it helps that I’m self-employed), or hold it until I retire and thus have lower income. Or hold it until I die so my heirs get a step-up in basis (they might have recently changed this rule though). Or donate the property to charity someday. Lots of ways to avoid the recapture if you really want to. And even if you can’t avoid it altogether, the deferral is still valuable.
Third thought: whether I can be cash flow positive on a property largely depends where the property is. It is nearly impossible to be cash flow positive on a house in Silicon Valley for the first 10-15 years. But I can be cash flow positive on a Salt Lake City property the first year. It doesn’t mean the Silicon Valley house is a bad investment, but I’m much more dependent on appreciation to make it work. And I have to keep throwing money in for several years.
Fourth thought: I did exactly what another commenter is contemplating. I moved out of a home I owned to become a renter. I continue to own my old home and have it rented to a nice couple. Without going into the details, I’ll just say the situation is murderous on my taxes, despite the fact that my tenants pay me the exact same amount of rent that I pay my landlord. I knew this going in. The move was made for non-financial reasons. The tax code heavily favors owner-occupied real estate, and this is a perfect example of that favoritism.
Last thought: I agree with the post and comments that it’s better to have Schedule E mortgage interest (rental property) than Schedule A mortgage interest (itemized deduction) as long as you are able to use the Schedule E deduction. The post mentioned the standard deduction as the reason, but let me point out that it is true even if you itemize. The Schedule E deduction lowers your adjusted gross income, whereas the Schedule A deduction does not. This is very important because the phaseout for many deductions and credits is based on your adjusted gross income. An “above the line” deduction is generally more advantageous than a “below the line” deduction.
Sorry for the long comment. I don’t comment much. When I do I get my money’s worth.
Thanks for a great post Jonathan!
July 9th, 2009 at 11:28 pm
Thanks for sharing such great info, it will help many people.
August 14th, 2009 at 5:44 pm
Confused first time buyer just wants to know this: can I deduct mortgage interest on my taxes if I buy a 2-fam house and rent out one unit? Don’t throw schedules my way, just yes or no.
August 17th, 2009 at 11:31 am
The short answer is yes. But when it comes to taxes short yes or no is really not enough of an answer. The interest on the rental portion is a defiant yes. All cost of renting for profit are deductible.
The interest on the portion you live in … well it depends. If you have enough you can deduct it. Remember you get a standard deduction you must have more than that standard deduction to help you save on your tax.
Now the cool thing is the rebate being offered until the end of November, up to $8,000 for first time home buyers there are limits due to income. Remember November not the end of the year.
February 14th, 2010 at 12:53 pm
My wife and I have a rental propery and we make over 150K. How can we carry over the losses over for future income?
Thanks,
John
March 31st, 2010 at 5:47 am
we recently bought a second vacation home and are trying to sell the first. Can i deduct any of the expenses for the second home? we are going to rent the first one out until we sell it. what can i deduct on my return until i start generating income from rent. all this took place at the end of nov. So we are really renting it out in 2011.
Thanks for any help.
April 2nd, 2010 at 4:48 am
mariebry,
Here are the rules, you can deduct all real estate taxes, you can deduct mortgage interest on two homes (but only the interest on the first $1,000,000) Now if you convert one house to rental for profit you report all the rent as gross income and all the expense (including depreciation) you do this on a Sch E.
This is the real boiled down version.
September 22nd, 2010 at 3:20 pm
does anybody know the answer to this:
1.buy investment property with cash-house worth $250k
2.take out morgage on the home i live in of $400k (do not have morgage at this time)
3. can i use the interest on $200k of morgage on primary residence to use as interest expense for investment property?
thanks
April 10th, 2011 at 5:09 pm
Question regarding transition of rental property to non-rental property.
I owned two homes in 2010:
Home “A” = lived in this home from Jan thru mid-Nov. Put up for sale in mid-Nov and sold in 2011.
Home “B” = rented this home out all of 2009 as well as Jan thru May 2010. This home sat empty from June thru mid Nov 2010. In mid Nov 2010, I moved out of Home “A” and into Home “B”.
I carried a passive loss over from 2009 to 2010. For 2010, I have additional passive losses for the five mths the home was a rental.
I am confused regarding two things at this point:
1. I treated the rental property as passive b/c I thought that you had to be a real estate professional in order to consider the income to be non-passive. I just read on this blog that if you check on the property or collect a rent check, you can go w/ non-passive so am now wondering if I should have considered non-passive in 2009 and 2010.
2. I read on the net that in the year you cease the passive income, you can take the passive loss carryovers against regular income. Wondering if anyone can confirm this. If this is true, then it won’t matter that I treated as passive activity since I’ll get to take all of the loss in 2010.
Thanks!
July 11th, 2011 at 1:34 pm
I am about to put an offer on a modest $180,000 cabin (my 2nd home). I CAN pay cash, but and concerned that doing so will cause me to NOT have a deduction. Certainly not leveraging has its advantages, but a 10 year fixed at 3.5% interest seems like a great time to borrow this money and hold on to my cash.
Am I better
1) Paying cash for the cabin
2) Borrowing at these great rates
also,
Is there a benefit for me renting this out over a few ski weekends in the winter? I don’t need the money, but does this allow me to deduct some additional expenses?
August 9th, 2011 at 1:51 pm
I have the same question as Bill: If I borrow 400K from my primary residence and purchase 400K worth of rental properties, can I deduct the mortgage interest on Sch E as opposed to Sch A? Thx.
August 13th, 2011 at 11:05 pm
If one takes out a mortgage to be deductible on Sch A it must be used to buy, build, or improve your residence.
If you borrow money to buy rental property that interest is an expense to be taken against rental income it does not matter if it is secured or not.
I am a professional tax preparer.
August 15th, 2011 at 12:16 pm
Rick – Here is your quote:
“If you borrow money to buy rental property that interest is an expense to be taken against rental income it does not matter if it is secured or not.”
Question: what if the money you borrow to buy rental property is secured by your primary residence?
August 16th, 2011 at 8:48 pm
John,
It does not matter what is securing the loan, if you could do it, it could be an unsecured loan (good luck with that nowadays). If the loan proceeds were used to buy the rental house the interest is an expense on SCH E.
October 9th, 2011 at 7:20 pm
Rick,
I’m upside down on my mortgage and my partner is no longer helping me with the mortgage so I’m thinking of renting out my house and renting an apartment for myself. I’m trying to avoid a short sale or foreclosure.
I can’t get enough rent to cover my mortgage, so I wanted to know if I can deduct the mortgage interest, which would make if easier for me to charge less rent.
October 15th, 2011 at 7:22 pm
The short answer is yes. In fact if you are getting the fair rental value or more you can deduct your mortgage interest real estate tax depreciation (you must do this) and any other expense (home assoc dues perhaps) on a Sch E this may give you a loss (many rental properties have a tax loss) this would lower your income tax. This might further help your situation.
October 18th, 2011 at 12:55 pm
@Rob…
#1 pay cash for the cabin, assuming it will not exhaust all your cash reserves.
Ask yourself… if you owned this $180,000 cabin outright would you go out and get a 10 year fixed 3.5% loan because the rates are great and you’d get a tax deduction? You’ll wind up paying the bank thousands of dollars in interest just to get a tax break.
November 9th, 2011 at 9:41 am
Question –
We recently purchased a new home, and put our condo on the market. After 3 months with only 2 poor showings, we listed it for rent, and it was rented within a week.
The rent we are collecting would cover the cost of the mortgage if it were not for the 1 month + $75/mo fee we have to pay to the management company that collects rent and maintains the property.
I understand that we will be able to write off the mortgage interest for our new home, but I am confused as to handle the condo. For the first 6 months of the year, it was our primary (and sole) residence, so that will be mortgage interest.
I understand that the day we listed it for sale/rent it became a rental property, so I can begin depreciation starting when it was advertised, so I will be able to claim 1/2 a year of depreciation on the asset.
Here’s my question: if we are getting ~1000/mo in rent, but 500 is going to interest, does that mean I can write off 500 of the rent, but the remaining 500 will be counted as rental income? In this scenario, how would it look like a loss when reported?
Thanks
November 28th, 2011 at 10:03 am
To follow up on Will’s post:
Most condo’s have HOA’s (home owner association) fees. In a rental situation would these costs be captured as additional expenses in a schedule E?
$1,000 rent
$500 interest
$200 principle
$200 HOA
Thoughts?
November 29th, 2011 at 10:21 am
Will and Jon,
The Sch E is a simple income statement. Rent is the income. Depreciation, HOA dues, Mortgage interest, supplies, cleaning and maintenance, management fees etc are expenses, don’t forget mileage to meet with renters or RE agents or management agents. If the rent is more than the expense there is a gain if not a loss.
December 1st, 2011 at 12:43 pm
What if the rental property is in another country? 100% of the time rented with mortgage paid to the foreign bank through a foreign account with money received from the rent in that country.
I understand the depreciation would be 40 years instead of 27.5 but for the mortgage interest as an expense , is it still treated the same on Schedule E?
With regards the mortgage interest deduction on sch A, would this property not be a “qualified home” and therefore the sch A deduction would not be possible but the expense on sch E is?
Any other implications to consider for a foreign rental property
Thanks.
December 6th, 2011 at 8:25 am
Steve,
If you are a US citizen you must report your world wide income. so there is no difference you just have to convert to USD. You may choose to elect 40 year not required. But if you started with 40 year must continue.
December 6th, 2011 at 8:31 am
Thanks
Not a citizen, but am a permanent resident.
are you absolutely sure about not having to do 40 years?
So i presume you are saying too that 100% of mortgage interest can be claimed as an expense.
Do i take the exchange rate on each date the mortgage is paid and get an average of them or pick the lowest/highest (or most favorable conversion)?
December 6th, 2011 at 9:21 am
Same applies for permanent resident. And Yes I am sure feel free to read Pub 527. But, you may use 40 if you desire, and if you have started with 40 year you must continue. And yes 100% of that cost is an expense on SCH E. Exchange rate should be figured each time there is a transaction. Also if there is a tax paid to a foregn government it can be taken as a one for one credit on form 1116, as long as it is not a government that support terrorism
December 13th, 2011 at 11:13 am
I presently have a owner occupied property with an adjustable rate of 2.875. I also have an investment property with a rate at 3.625. The former is fixed for the next five years while the latter adjusts every 6 months based on LIBOR. The principle owed on each property (around 290000) is near the same. For tax purposes which property would it be better to pay-off in the next 2-3 Years?
December 13th, 2011 at 8:38 pm
Ive,
Sadly there isn’t enough information to say. It depends on your marginal tax rate, the amounts of your other SCH A deductions, whether you are affected by AMT … etc.
As my engineering economy professor once said “least cost is almost always the right answer”.