Tax time can be stressful for rental property owners, especially when trying to keep track of all your tax deductions. For landlords that have been in the game for a while, you may have a good grasp on which deductions are allowed and which are not, but for those new to rental property investing, the answers may not be so clear.
One worry that often surfaces among landlords and accountants concerns mortgage payments on rental properties and whether or not to include them as an expense during tax time.
In this article, we’ll take an in-depth look at whether or not a landlord can claim mortgage payments as a rental property tax deduction.
- A typical mortgage payment can comprise all or some of the following elements: principal, interest, taxes, and/or insurance (PITI).
- While the principal portion of a mortgage payment is not an expense (because you are simply paying down your loan balance), the remaining items, including mortgage interest, property taxes, and insurance, can typically be deducted against the income received from the properties. Note that only the actual property tax and insurance amounts paid (by you or your lender) can be deducted. You cannot simply assume that whatever you paid into escrow as part of your mortgage payment is exactly the same amount actually paid to the tax collector and/or your insurer. You should reconcile these amounts before tallying up your deductions for the year.
- The various parts of a mortgage payment are usually reflected on different rental property financial reports, including the profit and loss (P&L) statement, real estate balance sheet, and cash-flow statement.
What’s in a Rental Mortgage Payment?
Not every landlord has the same setup, but a lot of the time, a typical rental property mortgage payment consists of the following:
- Principal payment
- Mortgage interest
- Escrow for property taxes
- Escrow for property insurance
The last three components of the payment—mortgage interest, property taxes, and property insurance—are tax-deductible expenses, subject to the disclaimer above regarding reconciling escrow payments versus actual amounts paid.
However, the portion of the mortgage payment applied to the principal is not tax deductible because this part of the payment reduces your outstanding loan balance dollar for dollar. There is no “expense” within a principal payment.
How a Rental Property Mortgage Is Recorded
A mortgage payment impacts the Net Cash Flow (NCF) report and the real estate Balance Sheet. For example, let’s assume that a $1,000 mortgage payment consists of the following:
- Principal: $165
- Interest: $640
- Taxes (escrow): $125
- Insurance (escrow): $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 balance sheet is then reduced by the amount of the payment applied to the principal.
Here’s how each component of the mortgage payment is recorded on the Balance Sheet and the Net Cash Flow report:
In this example, the monthly mortgage payment of $1,000 decreases net cash flow by $835. Because the outstanding mortgage loan balance is reduced by $165, the owner’s equity on the real estate balance sheet increases by $165.
How a Rental 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 in and out of a rental property’s ledger.
For example, when a tenant’s rent payment of $2,000 is deposited into the property’s checking account, $2,000 is added to income. Then, when part of the tenant’s rent payment is used to pay the $1,000 mortgage payment, $1,000 shows up as a negative cash flow amount:
No distinction is made between the $1,000 rent payment and specific mortgage payment components like escrows when recording cash flow. A cash-flow report concerns money moving in and out over a specific reporting period.
Rental Property Mortgage Interest Deduction
Mortgage interest is a popular rental property deduction. You can usually deduct mortgage interest as a business expense for investment properties like a rental.
How to calculate rental mortgage interest
Your mortgage company sends you an IRS Form 1098 each year, showing how much you’ve paid in interest throughout the year. If part of your payment includes money that goes into an escrow account to cover taxes and insurance, your mortgage company should also report that to you.
Remember that while home mortgage interest is reported on Schedule A of the 1040 or 1040-SR tax form, rental property mortgage interest is reported on Schedule E.
How to report mortgage interest expense
When the mortgage lender sends Form 1098, they will also send a copy to the Internal Revenue Service (IRS), who typically uses that information to cross-check what you report on your federal tax returns.
In addition to reporting rental income and mortgage interest expense, Schedule E is also used to report 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 among other key items.
How to Track Rental Property Interest Expenses
Having a digital record comes in handy for tasks like reconciling bank and mortgage accounts, completing repairs requested by a tenant, or verifying that a security deposit was returned. The same goes for keeping track of mortgage interest expense throughout the year.
Stessa helps make this seamless by connecting directly to your lender to gather payment data in real time. Regardless of how you track your interest expense, it’s nice to be able to quickly calculate the annual total at the end of the year, instead of having to wait for the tax statement from your bank or lender.
Create a Net Cash Flow Report
To accurately track the different types of tax-deductible interest payments on a rental property, the interest category of the Net Cash Flow report may be divided into several subcategories, each with an individual line item or account code.
Possible Net Cash Flow subcategories:
- Interest expense
- Mortgage interest, first loan
- Mortgage interest, second loan
- Credit card interest
- Personal loan interest
- Total interest expense
In addition to the above, you may be able to amortize and then deduct origination fees and points used to purchase or refinance your rental property, along with interest on unsecured loans used to improve your rental property.
The best practice when investing in real estate is to always maintain a digital record that documents a series of actions, such as receiving rent from a tenant each month, paying property expenses, and making the monthly mortgage payment.
Maintain accurate records
In addition, the IRS recommends that real estate investors maintain solid records to substantiate deductible expenses, in the event that a return is selected for an audit.
If an investor cannot provide evidence to the IRS to support items reported on a tax return, additional taxes and penalties may be incurred. Documentary evidence to prove expenses includes receipts, canceled checks, and bills with proof of payment.
Creating a traditional paper trail using a spreadsheet, printer, and filing cabinet is possible but can be very time-consuming. It can also be far too easy to understate income, overstate expenses, or misplace a document when doing everything by hand.
Track rental expenses with software
If you are a rental property owner looking to automatically track income and expenses, mortgage payments, and more, take a look at our top eight recommendations.
Many real estate investors currently use Stessa to track over 250,000 properties worth more than $60 billion in asset value. If you’re ready to start tracking things like mortgage interest using an all-in-one system, sign up for a Stessa account.
Will You Use This Rental Property Deduction?
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 typically fully deductible expenses.
Track all of your rental expenses using Stessa’s automated rental property accounting software. Get started for free.
Stessa is built to be flexible enough to handle different income and expense situations, but we do not provide specific tax, legal, or accounting advice. We strongly encourage you to consult with the proper professionals before filing your taxes.