Many tax deductions are available to real estate investors, including deducting operating expenses and depreciation from rental income to reduce pretax income. However, what can and can’t be deducted can be confusing when making a mortgage payment.

Let’s take an in-depth look at how to record the mortgage expense for rental property, along with some pointers a landlord can use to create the record trail that comes with real estate investing.

Key takeaways

• A mortgage payment is comprised of Principal, interest, taxes, and insurance (PITI).
• While the principal portion of a mortgage payment is not an expense, the remaining costs of mortgage interest, property taxes, and insurance can be deducted from the income received.
• Parts of a mortgage payment are reflected on various rental property financial reports, including the profit and loss (P&L), real estate balance sheet, and cash-flow statement.

Are mortgage payments a tax-deductible expense?

The answer to this question is both “yes” and “no.” 

A typical rental property mortgage payment consists of principal, interest, property taxes, and insurance:

• Principal payment
• Mortgage interest
• Property taxes
• Homeowners insurance

The last 3 components of the payment—mortgage interest, property taxes, and insurance— are tax-deductible expenses. However, the portion of the mortgage payment applied to the principal is not tax deductible because the principal is the amount borrowed to buy a rental property that will be paid back.

How a rental property mortgage payment is recorded

A mortgage payment affects the P&L statement and the real estate balance sheet. For example, assume that a $1,000 mortgage payment consists of the following parts:

• Principal: $165
• Interest: $640
• Taxes: $125
• Insurance: $70

Each time a mortgage payment is made, the checking account balance is reduced by the total amount of the mortgage payment. The outstanding loan balance on the real estate balance sheet is reduced by the payment amount applied to the principal. Mortgage interest, property taxes, and insurance are recorded as expenses on the P&L, which reduces the net operating income (NOI) of a rental property.

Here’s how each component of the mortgage payment is recorded on the real estate balance sheet and the P&L:

In this example, the monthly mortgage payment of $1,000 decreases NOI by $835. Because the outstanding mortgage loan balance is reduced by $165, owner’s equity shown on the real estate balance sheet increases by $165.

How a mortgage payment affects cash flow

A cash-flow statement, also known as a cash-flow report or net cash-flow statement, reports the movement of cash into and out of a rental property’s bank accounts. 

For example, when a tenant rent payment of $2,000 is deposited into the property’s checking account, $2,000 enters the property. Then, when part of the tenant’s rent payment is used to pay the $1,000 mortgage payment, $1,000 goes out of the property:

When recording cash flow, no distinction is made between the components of the $1,000 rent payment (PITI). A cash-flow report is concerned with the amount of money moving in and out over a specific reporting period.

Example of mortgage expense on NOI

Now let’s look at the impact that mortgage expense has on the NOI of a rental property, as shown on the P&L:

The investor in this example can claim mortgage interest, property taxes, and insurance as tax-deductible expenses, reducing the amount of taxable NOI to $955.

Deducting interest on rental property

As a rule of thumb, a rental property owner can deduct interest payments made to acquire or improve a rental property. Common tax-deductible interest expenses include:

• Mortgage interest payments to a bank, credit union, or private lender loan used to acquire a rental property
• Interest payments made on a second loan or home equity line of credit (HELOC) on a rental property
• Loan interest payments for borrowed money to improve a rental property or make repairs
• Credit card interest payments for supplies or services used for a rental property
• Interest on a personal loan an investor makes for an item or service used in a rental activity

To accurately track the different types of tax-deductible interest payments on a rental property, the interest category of the P&L may be divided into several subcategories, each with an individual line item or account code:

• Interest expense
  • Mortgage interest, first loan
  • Mortgage interest, second loan
  • Repair loan interest
  • Credit card interest
  • Personal loan interest
• Total interest expense

How to report mortgage interest expense

A mortgage lender will send Form 1098, which details the mortgage interest paid during the year. The lender will also send a copy to the Internal Revenue Service (IRS) to compare to the information reported 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. 

In addition to reporting rental income and mortgage interest expense, Schedule E is also used to report rent property operating expenses to the IRS, including advertising, maintenance, repairs, commissions for leasing, property management fees, other interest paid (such as credit card interest), repairs, supplies, and taxes.

Tips for keeping track of mortgage expense

Investing in real estate requires a “record trail” that documents a series of actions, such as receiving rent from a tenant each month, paying property expenses, and making the monthly mortgage payment.

Having a record trail comes in handy for tasks like reconciling bank and mortgage accounts, taking care of a dispute with a tenant who claims the rent was paid on time when it wasn’t, or a security deposit wasn’t returned after a move-out when it was. In addition, the IRS requires a real estate investor to maintain a record trail with records substantiating deductible expenses if a return is selected for an audit. 

If an investor cannot provide evidence to the IRS to support items reported on a tax return, there may be additional taxes and penalties. Documentary evidence to prove expenses includes receipts, canceled checks, and bills with proof of payment.

It’s certainly possible to create a sort of record trail by using a spreadsheet and filing cabinet. However, it can be far too easy to understate income, overstate expenses, or misplace a document when doing everything by hand. 

That’s why many real estate investors are using free rental property management software from Stessa, a Roofstock company, to automatically track income and expenses, mortgage payments and interest, tenant leases and vendor receipts, and all other important information associated with rental property. In fact, Stessa is currently being used by tens of thousands of investors to track over 250,000 properties with over $60 billion in asset value. 

Getting set up with Stessa is quick, easy, and 100% free. Enter the rental property address, connect bank and mortgage accounts quickly and securely, and see portfolio statistics come to life from a single, comprehensive online dashboard. 

Income and expenses are automatically recorded to the correct tenant and property. Mortgage payments are broken down by principal, interest, property taxes, and insurance, and the P&L and real estate balance sheet are instantly updated. 

Monthly reports can be generated, including income statements, net cash flow, and capital expense reports. In addition, tax-ready financials can be exported with just one click to help make tax time a breeze. The Stessa Tax Center is a free resource available to members of the Stessa Community, with a suite of tax resources created with The Real Estate CPA, helpful how-to articles, and top tax-deduction tips for investors.

Final thoughts

Using rental property tax deductions to reduce taxable net income is one of the most significant benefits of owning rental real estate, along with earning recurring income and equity appreciation over the long term. While the entire mortgage payment of PITI doesn’t qualify as a tax-deductible expense, the portions of the monthly mortgage payment used for mortgage interest, property taxes, and insurance are fully deductible expenses.