There can be positive benefits to owning rental property as an investment. One of those benefits could be potential cash flow from tenant payments. However, most incomes are subject to some kind of tax, and rental income is no different. But if you took out a mortgage to buy or refinance your rental property, how is your rental income taxed?
The answer is that your rental income is taxed as ordinary income, whether the property carries a mortgage or not. But it might be possible to lower rental or other income with the help of mortgage expenses.
The IRS and Rental Income
According to the IRS, rental income is defined as “any payment you receive for the use or occupation of property.” So when your tenant hands over the monthly check in accordance with the lease you both signed, that’s rental income. It’s also income that is taxed in accordance with your particular tax bracket.
Rental income goes beyond the monthly check. Advance rent and non-refundable security deposits also fall into this bucket. So does payment from your tenant for canceling the lease. What if a tenant pays any expenses like utilities or maintenance? This is also considered rental income.
Mortgage Interest and Other Potential Deductions
How does your mortgage figure into rental income? The mortgage principal – in other words, the amount you borrowed to buy or refinance your rental property – can’t be used to write off rental income. The principal is added to your property’s basis, where it’s depreciated over 27.5 years (if it’s a residential property).
But the added component of a mortgage – specifically, the mortgage’s interest and insurance premiums – can be used to help reduce taxable rental income. Other mortgage-related tools that could be useful in offsetting taxable rental income include:
- Mortgage interest payments on loans used to improve your rental property
- Credit card interest generated by goods or services used for your property
There’s another caveat to mortgage interest deductions. Specifically, if you live in that rental property for part of the year, you can’t claim mortgage interest expense as a deduction while you live there. For instance, if you bought a vacation home with a mortgage, and live in it for three months of the year (while renting it out for the other nine months), you can’t use mortgage interest deductions – or other deductible expenses – while you live in that home.
Taxes are Taxes
Whether you bought a rental property with cash or a mortgage, you will be taxed on that rental income. A mortgage doesn’t really enter into the situation. However, expenses connected with the mortgage (again, not the principal alone) could possibly be used to offset some of that rental income. To ensure that you’re following the IRS rules, contact your tax advisor for assistance.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Programs that depend on tenants for their revenue may suffer adverse consequences because of any financial difficulties, bankruptcy or insolvency of their tenants.
Hypothetical examples shown are for illustrative purposes only.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
