Disclaimer: As with most of this series, the focus is on long term rental property income and expenses that are filed as part of an individual tax return as opposed to a business tax return. However most of what I write does apply to short term rentals as well. Nothing in this article should be viewed as specific tax advice for your tax situation. Any information should be verified using proper sources such as (but not limited to) IRS instructions, IRS publications, and the tax code.
Wealth building through real estate often includes the use of debt. Debt can be a useful tool and it seems reasonable to expect that the costs of debt should be a tax deduction for real estate investments and for business. Some of the treatment of debt in the tax code is obvious and some is less obvious. Some of what is seen with taxes and debt is more common. Let’s start with what is most common, the mortgage payment.
The Mortgage Payment
Occasionally I run into first time landlords who have deducted their entire mortgage payment as an expense. This is NOT correct. You CANNOT deduct the principal portion of your payment since that really isn’t a cost for you. I know it feels like a cost. It certainly reduces your cashflow. But if you pay $100 of principal then you gain $100 of equity. So net zero. For other types of debt the gain may be less clear, but the principle remains, you don’t deduct principal. You CAN deduct the interest portion. If you pay PMI (private mortgage insurance premiums, which protect the lender), that portion of the payment is also deductible.
But what about the payments into escrow for real estate taxes and insurance? Those are NOT deductible, but the actual payments for real estate taxes and insurance from the escrow account ARE deductible. This is because money in an escrow account is still your money.
Please note that if the property has split use between personal and business (rental), then these deductions are allocated based on that use.
Other Loans and Credit
Interest can be deducted for any loan or credit line used for valid business or rental property spending. Some common borrowing methods include a home equity loan, a home equity line of credit, a personal loan, or even a credit card. Typically fees or charges paid regularly along with the loan or credit payments can also be deducted. It may sound strange that you can deduct interest from a personal loan, but this is because of interest tracing and it is a valid deduction only when the funds are used for a valid business purpose.
This is an important concept since often those engaged in wealth building through real estate often borrow using one property as collateral in order to buy another property. When money is borrowed, the deductibility of the related interest expense is dependent on how the borrowed funds are actually used and NOT by any collateral. This concept applies to cash out refinancing of mortgages as well as the other borrowing mentioned above. It also applies to financing costs, which we’ll discuss later. Let’s look at an example:
Sarah gets a home equity loan of $100,000 on rental property A. Sarah uses $40,000 to remodel several rooms in property A. Sarah uses $20,000 for her dream vacation. And finally Sarah uses $40,000 to help purchase rental property B. Property A gets allocated 40% of the interest as a deduction. Property B gets allocated 40% of the interest as deduction. The dream vacation gets allocated 20% of the interest -but there is no deduction for a vacation. This continues for the life of the loan. So 20% of the interest is never a tax deduction. If Property B gets sold and the loan is still “on” property A, 40% of the interest is still all that gets deducted for property A.
Expenses paid to obtain or refinance a mortgage
When a property is bought as an investment the costs associated with borrowing or financing are NOT added to the property’s basis. Some closing costs are added to the basis, but not those associated with borrowing. Instead, borrowing costs are amortized over the life of the loan. This is similar to depreciation, in that the costs are spread out over time, which in this case is over the life of the loan. Loan costs that are amortized (or capitalized) may include items such as points, mortgage insurance premiums, loan assumption fees, cost of a credit report, fees for appraisal required by the lender, and refinance fees. IRS Publications 527 and 551 provide more detailed information.
If a portion of a refinance loan is used for another property or purpose, then the appropriate portion of the loan costs should be allocated to the other property or purpose, just like the interest.
Some final words
I want people to avoid tax errors and this drives me to write many of the articles I write including this one. I mentioned the mortgage payment error I’ve seen. Folks do mess up interest tracing and also the improper handling of mortgage and refinance loan costs is quite common. One way to help you avoid errors besides reading my articles is to use IRS instructions and publications when you are preparing your tax return.