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.
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.