tax question for rental investing

General Real Estate Investing
1

so let’s say that you take out a loan to buy a house for the purpose of renting it out.

if the money you make in rental that year is equal to the money you had to pay into paying the loan back…i.e. you made no profit and kept no money for yourself that year, do you still have to pay taxes on the rental income?

Is it a situation where you have to declare it as income and is eligible for taxation as such, but since you are also paying out the entire amount you received back toward the loan, you can deduct it from your taxes and thus not have to pay on it?

anyone know how this works?

thanks!!!

2

If your rental income just covers all your expenses, you breakeven at the end of the year. You may think you have no tax liability and you may be right, but the reality is even better.

Because you take a depreciation expense (that does not really cost you any money), your net rental income appears to be a negative amount – a net passive loss in IRS terms. Up to $25K in net passive losses can be used to offset other ordinary income under certain income limits.

Getting back to your specific question, if the rent just covers the loan payment, do the two cancel each other out for a zero income? The answer is almost, but not quite. If you have an amortizing loan, some of your mortgage payment is applied to principal, some to interest, perhaps some is also escrowed to pay taxes and insurance. The actual amount of mortgage interest, taxes and insurance premiums paid during the year are expenses against your rental income. The amount you pay to reduce your loan’s principal balance is not an allowed expense.

3

hey thanks for the response Dave. I think I’m still unclear on something though. you say that the reality is even better, but you said that the amount you pay to reduce your loan’s principal balance is not an allowed expense. well this seems like it would be a huge problem if you only take in the exact amount you need to pay the loan, since you can only deduct the amount of interest, taxes, and insurance premiums and nothing from the principle…because the majority of the loan would be principle right? the interest is only like 7% of the portion of the principle you are paying that year right?

let’s take the following overly simplistic example: (this could be way off base because I don’t really know how this would actually work)

let’s say you take out a $100,000 loan to buy a $100,000 dollar house at 7% for 10 years. so your payment would be $10,700 per year, $10,000 toward principle and $700 toward interest. you take in $10,700 in rental income, so you pay it all toward the loan. so you break even. HOWEVER, the $10,000 toward principle isn’t tax deductible, so you have to pay like 30% of it in taxes. so even though you broke even, you owe $3,000 to the IRS?

is this math right? I’m a total newbie so this is just my own speculation on how it would work.

thanks again!

4

First, let’s get the loan payments correct. A $100K amortizing loan at 7% interest for ten years has a monthly payment of $1,161.08. In the first year, you will have made 12 loan payments totalling $13,933.02. Of this amount, $6,773.18 will be interest, the rest is applied to the loan balance. Note that 7% of $100K is $7000, not $700. Because we have an amortizing loan, the interest paid each month goes down as the loan balance is reduced.

The $7,159.83 used to pay off your loan is not a tax deduction. The money you borrow is not taxed to you as income, so the money you pay back is not a deductible expense on your tax return.

Let’s say that your annual loan payments ($13,933.02), your property taxes ($1016.98), and your annual hazard insurance premium ($650) all total $15,600. Your property was rented for the entire year at $1300 per month. At the end of the year, you collected $15,600 in rental income. Your income covers your outflow, so you break even.

For tax purposes, however, your rental income is only offset by $8440.17 because the loan principal you repaid is not an allowed expense. It may appear that you have a taxable net rental income of $7,159.83, but you have not taken your depreciation expense. When you work the numbers, you find that you have an allowable depreciation expense of $2909.09.

On your tax return you will show a net passive income of $4250.74 even though you really broke even on a cash flow basis before taxes. In the 25% tax bracket, your taxable rental income will add $1063 to your total tax liability. in this instance, you will have to come out of pocket $1063 to pay your taxes.

In this example, we have a net taxable income from rental operations because we used a 10 year loan term. Using a 30 year term reduces your monthly loan payment to $665.30, or a total of $7983.63 the first year. Now when your principal, interest, taxes and insurance equal your total rental income, you will have only $1015.81 in non-deductible principal payments. Adding in the depreciation expense of $2909.09 gives you a net passive loss of $1893.28 even though you broke even on a cash flow basis before taxes. In the 25% tax bracket, your net passive loss will reduce your total tax bill by $473.32.

Does this clear it up for you?

5

wow, thanks dave, that really clears things up.

I was thinking that 7% on a $100,000 loan would come to $107,000 total that you would have to pay back. then I used $700 per year because I was dividing it over the course of 10 years. but under your example, it looks like the 7% is actually paid on the total amount of the loan PER YEAR. so actually, you’re paying much more than 7% interest on the $100,000 loan in total. am I getting this right?

so your depreciation expense doesn’t change whether you use a 10 year term or a 30 year term? very interesting. so how do most rental investors do 30 year terms and try to live off of the profits from many many houses that they’ve taken out loans for? just wondering I guess the point of going the rental route of REI.

thanks again for your responses!

6
...under your example, it looks like the 7% is actually paid on the total amount of the loan PER YEAR. so actually, you're paying much more than 7% interest on the $100,000 loan in total. am I getting this right?
No, just 7% per year on the money borrowed. In the first month of an amortizing loan, you borrowed $100K, so at the end of your first month of the loan, you pay one month's interest at 7% APR for the money you borrowed. Since 7% is the annual rate, you have to divide that by 12 to determine the rate you pay each month. Because your first monthly payment also included a small amount to reduce the loan balance, your second month's interest payment will be a little lower than the first month. The interest rate is still 7% APR, but for that second month, the amount of money borrowed was less than the first month.

This is the nature of an amortizing loan. If you have a financial functions in your spreadsheet, you might experiment with building an amortization table. Plug in different numbers and see what happens.

so your depreciation expense doesn't change whether you use a 10 year term or a 30 year term?
That is right. Your property's depreciation basis is recovered over 27.5 years for residential rental property.
... so how do most rental investors do 30 year terms and try to live off of the profits from many many houses that they've taken out loans for? just wondering I guess the point of going the rental route of REI.
I can't answer for anyone else. I can only speak for myself. My answer is that I couldn't live solely on rental income. I suppose there is a point -- maybe 25 properties -- where my cash flow would be enough to support my lifestyle. But what does the typical rental property investor do until he gets there?

That is the beauty of real estate investing. There are more than five or six ways to make money. Sandwich lease options, subject to deals, wholesale flips, rehab flips, contract assignments, birddog fees, all generate quick cash. To get more money, find another property and do another deal. Invest some of your profits in your rental income portfolio – into your retirement.

If you want, just let rental property acquisition be a sideline, a hobby. Keep your day job for the salary and medical benefits, even for the retirement package if there is one. Invest in rental property to supplement your income, not to replace it, but to build a comfortable cash flow generator for the time when you do decide to “retire” from the daily 9 to 5. That’s what I did. I hung up my holsters seven years ago when I turned 49 and I have not looked back since.

One thing to master in rental property investing is the cash flow analysis. With a good cash flow analysis tool, and a disciplined approach to investment, you won’t make any really disasterous decisions. Learn to only buy property that produces a positive cash flow, buy below FMV value so you have equity going in, and use 1031 exchanges when an exchange will improve your equity or cash flow.