Real estate investors can take advantage of a variety of tax breaks, such as the ability to deduct operating costs and depreciation from rental income to lower their pretax income. But when making a mortgage payment, it can be unclear what can and cannot be deducted.
Let’s examine in greater detail how to record mortgage expenses for rental property and offer some advice for landlords on how to establish the paper trail that goes along with real estate investing.
Are mortgage payments a tax-deductible expense?
The answer to this question is both “yes” and “no.”
Principal, interest, property taxes, and insurance make up a typical mortgage payment for a rental property:
Mortgage interest, real estate taxes, and insurance are the final three components of the payment that are tax deductible. However, because the principal is the sum borrowed to purchase a rental property and will be repaid, the portion of the mortgage payment applied to the principal is not tax deductible.
How a rental property mortgage payment is recorded
The P&L statement and the real estate balance sheet are both impacted by mortgage payments. Assume, for illustration, that a $1,000 mortgage payment is composed of the following components:
The total amount of the mortgage payment is deducted from the checking account with each mortgage payment. The payment amount applied to the principal reduces the outstanding loan balance on the real estate balance sheet. When recorded as expenses on the P&L, mortgage interest, property taxes, and insurance lower a rental property’s net operating income (NOI).
The real estate balance sheet and the P&L reflect each mortgage payment component as follows:
In this instance, the $1,000 monthly mortgage payment reduces NOI by $835. Owner’s equity as shown on the real estate balance sheet rises by $165 as a result of the $165 reduction in the outstanding mortgage loan balance.
How a mortgage payment affects cash flow
The movement of money into and out of the bank accounts for a rental property is shown on a cash-flow statement, also known as a cash-flow report or net cash-flow statement.
For instance, when a tenant deposits a $2,000 rent payment into the property’s checking account, $2,000 is brought into the asset. Then, $1,000 leaves the property when a portion of the tenant’s rent payment is used to cover the $1,000 mortgage payment:
No distinction is made between the parts of the $1,000 rent payment (PITI) when recording cash flow. The amount of money coming in and going out over a specific reporting period is the focus of a cash-flow report.
Example of mortgage expense on NOI
Let’s now examine the effect that mortgage expense has on a rental property’s NOI as displayed on the P&L:
In this example, the investor can reduce the taxable NOI to $955 by deducting mortgage interest, property taxes, and insurance.
Deducting interest on rental property
Generally speaking, a landlord can write off interest payments made to purchase or improve a rental property. Common tax-deductible interest expenses include:
The interest category of the P&L may be divided into several subcategories, each with a unique line item or account code, in order to accurately track the various types of tax-deductible interest payments on a rental property:
- Mortgage interest, first loan
- Mortgage interest, second loan
- Repair loan interest
- Credit card interest
- Personal loan interest
How to report mortgage interest expense
A mortgage lender will deliver Form 1098, which contains information about the yearly mortgage interest paid. Additionally, the lender will send a copy to the Internal Revenue Service (IRS), who will compare it to the data on the federal tax return.
Mortgage interest expense is then reported to the IRS at the end of each year on Schedule E (Form 1040), Supplemental Income and Loss, and is included with the federal tax return.
Schedule E is used to report rent property operating expenses, such as advertising, maintenance, repairs, commissions for leasing, property management fees, other interest paid (such as credit card interest), repairs, supplies, and taxes, in addition to rental income and mortgage interest expense.
Tips for keeping track of mortgage expense
A “record trail” is needed when investing in real estate to keep track of a number of actions, such as collecting rent from tenants on a monthly basis, paying property expenses, and making mortgage payments on time each month.
For tasks like balancing bank and mortgage accounts, handling a dispute with a tenant who claims the rent was paid on time but it wasn’t, or making sure a security deposit was returned after a move-out when it was, having a record trail is helpful. Additionally, if a return is chosen for audit, the IRS mandates that a real estate investor maintain a record trail with documents supporting deductible expenses.
An investor may be subject to additional taxes and penalties if they are unable to provide the IRS with proof to back up the information they report on a tax return. Receipts, canceled checks, and bills with payment receipts are examples of documentation needed to prove expenses.
Using a spreadsheet and filing cabinet, it is possible to create a kind of record trail. However, when doing everything by hand, it can be far too simple to understate income, overstate expenses, or lose a document.
For this reason, a lot of real estate investors use free rental property management software from Stessa, a Roofstock company, to automatically track earnings and expenses, mortgage payments and interest, tenant leases and vendor receipts, and all other crucial data relating to rental property. In fact, tens of thousands of investors are using Stessa right now to monitor over 250,000 properties with a total asset value of over $60 billion.
Stessa setup is quick, simple, and completely free. Enter the address of the rental property, securely link bank and mortgage accounts, and view portfolio statistics from a single, all-encompassing online dashboard.
The appropriate tenant and property are automatically recorded for income and expenses. Principal, interest, property taxes, and insurance are separated out from mortgage payments, and the P&L and real estate balance sheet are immediately updated.
It is possible to produce monthly reports that include income statements, net cash flow, and reports on capital expenses. Additionally, to make tax time easier, tax-ready financials can be exported with just one click. Members of the Stessa Community can access The Stessa Tax Center for free. It offers a variety of tax resources developed with The Real Estate CPA, helpful how-to articles, and top tax-deduction advice for investors.
Final thoughts
One of the biggest advantages of owning rental real estate, along with recurring income and long-term equity growth, is the ability to use rental property tax deductions to lower taxable net income. The portions of the monthly mortgage payment used for mortgage interest, property taxes, and insurance are fully deductible expenses, even though the entire mortgage payment of PITI is not.
FAQ
Can I deduct the mortgage interest on a rental property?
What Tax Deductions Am I Entitled to As a Property Owner Who Rents Out? If you receive rental income from renting out a home, you are entitled to claim a number of rental expenses on your tax return. These costs could include the interest on a mortgage, property taxes, operating costs, depreciation, and repairs.
Do I have to itemize to deduct mortgage interest on a rental property?
You cannot take the HMID on your rental properties as a landlord. But that’s actually a good thing because you can claim business interest on your Schedule E and deduct the mortgage interest on your rental properties. This provides much greater flexibility and exempts you from itemizing your Schedule A.