Managing expenses like mortgage interest for your rental property can be challenging for any landlord or rental property owner. Our guide will walk you through using these interest payments to lower your taxable income, providing financial relief.
Read on to learn how rental property mortgage interest deductions work, their limits, and their insights into various aspects.
- Rental property mortgage interest is deductible on Schedule E, offering tax relief for landlords.
- Deductible interest Payments: Primary and rented second homes, mortgage points, late fees, prepayment penalties, home equity loans, and pre-sale interest.
- Non-deductible interests include personal home loans, non-rental periods, and interest for owner-occupied parts of a property.
- Full mortgage interest deduction is available for rental properties, except for non-business related loans and owner-occupied portions.
- Eligible loans for deduction: First mortgages, HELOCs, second mortgages, home improvement loans, and fixed-rate loans for rental activities.
- Limitations apply for businesses with over $26 million in gross receipts, capping interest deduction at 30% of adjusted income. High-income landlords can opt for 100% deduction with longer property depreciation.
What is the Mortgage Interest Deduction (HMID)?
The Home Mortgage Interest Deduction (HMID) is a tax benefit primarily for homeowners. As a homeowner, you can elect to itemize rather than take the standard rental property tax deductions on your property taxes and claim the interest on the first $750,000 of mortgage principal you’ve borrowed on your Schedule A. Depending on your circumstances, the home mortgage interest deduction can save you a significant amount on your income taxes.
You can’t take the HMID on your rental properties as a landlord or rental property owner. But that’s actually a good thing because you can deduct the mortgage interest on your rental property as a business interest expense on your Schedule E. This offers much more flexibility and doesn’t require you to itemize your Schedule A.
For instance, you buy a rental property for $600,000 with a $400,000 mortgage. In the first year, you pay $20,000 in interest and earn $60,000 in rental income. You can deduct $20,000 in interest from your rental income, reducing your taxable rental income to $40,000. Your lender will provide you with Form 1098 annually, detailing the mortgage interest you’ve paid, which helps claim this deduction.
You can lower your taxable income by taking advantage of the rental property mortgage interest deduction, which does not apply to investment properties.
What Qualifies As Deductible Mortgage Interest?
Investment property mortgage interest deductions impact your tax return. Here’s a breakdown of mortgage interest deduction scenarios:
Primary Residence Mortgage Interest
This includes interest on mortgages for a variety of primary residences, such as houses, condos, and even houseboats, as long as they have essential living facilities. It’s applicable even in cases like divorce settlements.
Non-Taxable Housing Allowance Considerations
Those receiving housing allowances from military or ministry services can deduct the interest they pay on their mortgage.
Second Home Mortgage Interest
When deducting mortgage interest on a second home, the rules depend on the property’s use:
- For a vacation home used only personally, mortgage interest isn’t deductible against rental income but may qualify for a personal deduction.
- If renting out a second home part-time, deduct mortgage interest for the rental period only, e.g., 7.7% for four weeks of rental.
- In a mixed-use property, deduct interest based on the rented area’s proportion, like 40% for a 1,200 sq-ft rented space in a 2,000 sq-ft home.
Deducting Mortgage Points
The cost of mortgage points, and prepaid interest, can be deductible. These points must be paid directly to your lender and can be deducted either immediately or over the loan’s duration.
Late Mortgage Payment Charges
Charges for late mortgage payments are deductible, but avoiding late payments is wise to protect your credit score.
Early Mortgage Payoff Penalties
Penalties incurred for early mortgage payoff can be deducted, provided they are not linked to additional services or loan costs.
Home Equity Loan Interest
Interest on loans taken against home equity is deductible if used for home-related improvements or purchases.
Interest paid on your mortgage before selling your home is deductible up to the point of sale.
What's Not Deductible?
When managing your rental property finances, knowing what mortgage interest you cannot deduct is equally important. Here’s a quick overview:
1. Personal Home Loan Interest: Interest on loans for your personal residence is not deductible against rental income.
2. Non-Rental Periods: Interest accrued during periods when the property wasn’t available for rent isn’t deductible.
3. Owner-Occupied Portion: For a property where you live and rent out a part, the interest corresponding to your living area is not deductible.
4. Prepaid Interest Limitations: Prepaid interest, such as points or origination fees, isn’t immediately deductible but is spread over the loan’s term.
5. Second Home for Personal Use: Interest on a second home used for personal purposes doesn’t qualify for deduction against rental income.
6. Non-Business Related Loans: Interest on loans not used for your rental business, including personal loans or credit card debts unrelated to rental activities, is not deductible.
Rental Property Interest Deductions at a Glance
|Interest on loans that support your rental business
|Interest on loans for your own home
|Interest for the days the property was available for rent, even if you didn't have a tenant
|Interest for the days the property was not available for rent
|Interest for the portion of your owner-occupied home that you rent out
|Interest for the portion of your owner-occupied home that you live in
|Interest on loans that was applied within the tax year
|Prepaid interest such as points and origination fees
|Interest on a second home that's rented out
|Interest on a second home for personal use
|Interest on conventional and unconventional mortgages, private home loans, home equity lines of credit, unsecured loans and lines of credit, and credit cards when the money borrowed is used in your rental business.
|Interest on loans when the money is not used in your rental business.
How Much Mortgage Interest is Deductible?
You can deduct all the interest you paid on a mortgage for your rental property, with a few exceptions:
- The mortgage doesn’t support your rental business
You can only deduct mortgage interest for loans used in your rental business, not your personal residence. The IRS could ask for records showing how the loan was used and will need to see if you followed their strict rules about how the money needs to be traced. Use rental property bookkeeping software to keep track of all your rental expenses so you can stay organized at tax time and have records of all tax deductions at the ready in case you need them.
- You occupy part of the property
Let’s say you own a detached home in Indiana and rent out a basement apartment. You can only deduct the portion of interest that covers the basement. The simplest way to calculate this is by using the floor area of the home. If the basement unit comprises 1/3 of the square footage, you can deduct 1/3 of your mortgage interest as an expense.
For example, if the home had a total floor area of 3,000 square feet, and you rented out the 1,000 square-foot basement suite, the rented portion of the home would be 33.3% (1000 sq-ft / 3000 sq-ft = 33.3%). If your annual mortgage interest paid for the home was $12,000, you could deduct $4,000 as an expense ($12,000 x 33.3% = $4,000).
You may still be able to deduct the interest on your personal portion of the mortgage on your Schedule A.
- The rental property wasn’t available for rent for the entire year
The same is true if the unit was only available for rent for part of the year. If you own a condominium and began renting it out on July 1st, you would only be able to deduct half of the mortgage interest you paid that year. If you use your rental property for short-term rentals, you can only claim the days the rental property was actually available for rent (even if you didn’t have a renter on all of those days).
- The mortgage interest doesn’t apply to the current property tax year
IRS rules state that you can only deduct interest in the year it was applied, which is not necessarily the year it was paid. Money spent on points and origination fees must be deducted over the life of the loan, even if they were paid upfront.
What Loans Qualify For A Mortgage Interest Deduction?
The following rental property loans qualify for mortgage interest deductions:
- First Mortgages: Interest on the primary loan for buying your rental property.
- Home Equity Lines of Credit (HELOCs): Interest on HELOCs used for rental property-related expenses.
- Second Mortgages: Deductible interest on additional mortgages for your rental property.
- Home Improvement Loans: Interest on loans specifically for improving your rental property.
- Fixed-Rate Loans: Interest on fixed-rate loans used for rental property purposes.
Key to this deduction is the ability to demonstrate that the loan was indeed used for rental property purposes. Proper documentation and records are essential to validate your claims.
Limitations of Mortgage Interest Deductions
Is there a limit on mortgage interest deduction on a rental property? Yes, there are limitations on how much mortgage interest can be deducted based on the landlord’s income and the type of loan.
- Section 163(j) Limitation: This rule limits the amount of business interest that can be deducted. Specifically, the deduction is capped at 30% of the landlord’s adjusted taxable income, plus their business interest income and any floor plan financing interest.
- Gross Receipts Threshold: Businesses, including rental property operations, with average gross receipts exceeding $26 million over the past three years face a restriction. They can only deduct interest payments up to 30% of their adjusted taxable income.
- Exemption for High-Income Landlords: Landlords who earn income at or above the $26 million threshold can bypass these limitations. By filing a specific election on their tax return, they can deduct 100% of their interest expenses. However, this choice comes with a caveat: they must agree to depreciate their real property over longer periods than usual.
Final Thoughts: Tax Deductions for Rental Property Mortgages
There are lots of actual expenses and tax deductions associated with being a landlord or rental property owner, and mortgage interest is typically one of the largest expenses you will have. Fortunately, you can deduct your mortgage interest as an expense on your Schedule E to lower your rental property income and reduce your property taxes bill.
Rental property owners can only deduct the mortgage interest that is specifically related to their real estate business. Just as they can’t deduct the cost of their personal expenses, they can’t deduct interest on mortgages for their own home. However, the rental property owners may be able to deduct their personal mortgage interest on your Schedule A using the Home Mortgage Interest Deduction.
For the most part, you can deduct all of your rental property expenses against your rental income, including rental property taxes, advertising, insurance, maintenance costs, and even travel.
If you’re renting a separate unit in an owner-occupied home, such as a basement apartment, you can deduct a fraction of your mortgage interest equal to the fraction of the home that’s rented out. For example, if your rented basement apartment comprises ¼ of the home’s square footage, you can deduct ¼ of your mortgage interest on your Schedule E. You may also be able to take the HMID on your Schedule A for the remainder of your interest expense.
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Yes, as a rental property owner, you can deduct mortgage interest on your rental property. This is one of the main rental property deductions available, which can help reduce your taxable income.
Yes, there can be a limit on mortgage interest deductions for rental property, especially if you have high-income or own multiple properties. It's important to consult with a tax professional to understand any limitations specific to your situation and to ensure you're taking advantage of the full scope of rental property deductions available to you.
While many expenses can be deducted, such as the rental property mortgage rate interest and maintenance costs, not all expenses related to rental property are tax-deductible. Capital improvements, for example, are not immediately deductible but are typically depreciated over time. Always consult a tax expert to know all allowable rental property deductions.
Yes, as a taxes rental property owner, you are required to report rental income on your tax return. However, you can also claim rental property deductions to offset this income, including expenses such as property management fees, maintenance costs, and mortgage interest.
Rental property expenses like advertising, insurance, and maintenance are deductible. The interest on a mortgage for rental property, influenced by the rental property mortgage rate, is also deductible. It's important for taxes rental property owners to consult professionals for all potential deductions.
Absolutely! Obtaining a mortgage for rental property is a common way investors purchase real estate to rent out. However, the rental property mortgage rate might be slightly higher than for a primary residence due to the perceived increased risk associated with rental properties. It's crucial to shop around for the best rates and terms when seeking a mortgage for a rental property.