If you own a rental property in the United States, you may be wondering how your rental income is taxed, especially if you have a mortgage on the property. In this blog post, we will explain the basics of rental income taxation and how your mortgage expenses can affect your tax liability.
Rental Income Taxation with Mortgage
Rental income is any payment you receive for the use or occupation of your property, such as monthly rent, security deposits, advance rent, or payments for canceling a lease. You must report rental income on your tax return as ordinary income, regardless of whether you use the cash or accrual method of accounting. This means that your rental income is taxed at your marginal tax rate, which depends on your filing status and taxable income.
However, you can also deduct certain expenses related to your rental activity, which can lower your taxable rental income. These expenses include:
- Mortgage interest: You can deduct the interest you pay on your mortgage for your rental property, as well as any points you paid to obtain or refinance the loan. However, you cannot deduct the principal portion of your mortgage payments, which reduces your loan balance. The principal is added to your property's basis, which affects your depreciation deduction and capital gain or loss when you sell the property.
- Mortgage insurance premiums: You can deduct the premiums you pay for mortgage insurance on your rental property, such as private mortgage insurance (PMI) or FHA mortgage insurance. However, this deduction is subject to phase-out if your adjusted gross income (AGI) exceeds certain thresholds.
- Property taxes: You can deduct the real estate taxes you pay on your rental property, as long as they are based on the assessed value of the property and are imposed uniformly on all properties in the jurisdiction.
- Depreciation: You can deduct the cost of your rental property over its useful life, which is 27.5 years for residential property and 39 years for nonresidential property. Depreciation allows you to recover the cost of your investment in the property and reduce your taxable income. However, depreciation also reduces your property's basis, which increases your capital gain or loss when you sell the property.
- Other expenses: You can deduct any other ordinary and necessary expenses related to your rental activity, such as repairs, maintenance, utilities, insurance, advertising, legal fees, management fees, travel expenses, and home office expenses. However, you must allocate these expenses between personal and rental use if you also use the property for personal purposes.
Personal Use of Rental Property
If you use your rental property for personal purposes for more than 14 days or 10% of the total days when the property was rented at a fair market value, whichever is greater, you must treat the property as a personal residence for tax purposes. This means that you must divide your expenses between personal and rental use based on the number of days each year.
You can deduct mortgage interest and property taxes on both personal and rental portions of your property, subject to certain limits. However, you can only deduct other expenses on the rental portion of your property, and only up to the amount of your rental income. You cannot deduct any rental loss or carry it over to future years.
Suppose you own a condo that you rent out for $2,000 per month. You have a mortgage on the condo with an interest rate of 4% and a monthly payment of $1,500 ($1,000 principal and $500 interest). You also pay $200 per month for PMI and $100 per month for property taxes. You incur $300 per month for other expenses related to your rental activity.
You use the condo for personal purposes for 30 days during the year and rent it out for 300 days at a fair market value. Your rental income and expenses for the year are as follows:
- Rental income: $2,000 x 300 = $600,000
- Mortgage interest: $500 x 330 = $16,500
- Mortgage insurance premiums: $200 x 330 = $6,600
- Property taxes: $100 x 330 = $3,300
- Depreciation: ($200,000 / 27.5) x (300 / 365) = $5,945
- Other expenses: $300 x 300 = $9,000
Your personal use percentage is 30 / 330 = 9.09%, and your rental use percentage is 300 / 330 = 90.91%. Therefore, you can deduct the following amounts on your tax return:
- Mortgage interest: ($16,500 x 90.91%) + ($16,500 x 9.09%) = $14,900 + $1,500 = $16,400
- Mortgage insurance premiums: ($6,600 x 90.91%) + ($6,600 x 9.09%) = $5,999 + $600 = $6,599
- Property taxes: ($3,300 x 90.91%) + ($3,300 x 9.09%) = $2,999 + $300 = $3,299
- Depreciation: $5,945 x 90.91% = $5,405
- Other expenses: $9,000 x 90.91% = $8,182
Your taxable rental income is:
Rental income: $600,000
Less: Mortgage interest: ($14,900)
Less: Mortgage insurance premiums: ($5,999)
Less: Property taxes: ($2,999)
Less: Depreciation: ($5,405)
Less: Other expenses: ($8,182)
Taxable rental income: $562,515
Your taxable personal income is:
Mortgage interest: $1,500
Mortgage insurance premiums: $600
Property taxes: $300
Total personal income: $2,400
As you can see, your mortgage expenses can help you reduce your taxable rental income and lower your tax liability. However, you must also consider the impact of depreciation and personal use on your tax situation.
Rental income is taxed as ordinary income in the United States, whether you have a mortgage on the property or not. However, you can deduct certain expenses related to your rental activity, such as mortgage interest, mortgage insurance premiums, property taxes, depreciation, and other expenses.
These deductions can lower your taxable rental income and save you money on taxes. However, you must also follow the IRS rules on reporting rental income and expenses, especially if you use the property for personal purposes. To ensure that you are complying with the tax laws and maximizing your tax benefits, you should consult a qualified tax professional for advice.