Can You Deduct Mortgage Interest on a Rental Property?

Owning a rental property can be profitable for real estate investors. An owner may be actively investing or passively investing, depending on the property. As with many investments, the ability to deduct certain expenses is an essential component of the financial equation. One expense that investors ask about is the deductibility of mortgage interest.

The answer is yes. You can deduct mortgage interest on rental property as a business expense. This can potentially reduce your taxable income and save you money on taxes. To be eligible for the deduction, the property must be held for income production and be available for rent. You must also meet certain other requirements, such as keeping detailed rental income and expense records.

What expenses can I deduct from my rental income?

Typical expenses that investors can deduct from rental income are:

•       Property taxes
•       Operating expenses
•       Mortgage interest
•       Depreciation
•       Repairs

Operating expenses include maintenance, utilities (unless paid by the tenant), insurance, and advertising. You may not deduct expenses for improvements, but the cost may be recouped through depreciation.

Are there limits on how much interest I can deduct from a rental property?

You probably already know that the 2017 Tax Cuts and Jobs Act limits how much interest you can deduct from your primary residence. The TCJA disallows interest deductions for mortgage debt over $750,000. Homeowners can deduct interest on mortgage debt up to $750,000, but not beyond (except for mortgages in place before the legislation was passed).

Rental property owners report their rental income and expenses on Schedule E. For example, if you own a single-family home and rent it for $12,000 annually, you can deduct the interest on the mortgage loan you used to purchase that property.

However, suppose your property is a duplex, and you live in one unit and rent the other to a third party. If you have (as is likely) one mortgage for the entire property, only half the interest is eligible for deduction as a rental expense. If the interest you pay is $6,000 each year, you may deduct $3,000 on your Schedule E. However, since homeowners also have mortgage interest deductions, you can deduct a portion of the interest that covers your personal residence as well.

Similarly, suppose you rent a room in your primary residence to a third party. If you want to deduct mortgage interest on the portion of the home you rent, you can do so on a pro-rated basis. If the room is ten percent of the home's total square footage, you can deduct ten percent of the interest paid as a business expense. This is for renting that room.

What other limits exist on mortgage interest deductions?

The IRS does not allow you to deduct interest on a mortgage you refinance for more than the previous mortgage balance. For example, if you refinance an existing $400,000 mortgage and cash out an extra $200,000 to remodel or upgrade the property, you may only deduct the interest paid on the $400,000. The interest on the remaining $200,000 could be recouped through depreciation of the improvements.

Also, the cost of obtaining a mortgage (like fees and commissions) is not deducted like interest. These are treated as capital expenses and must be depreciated.