Does depreciating house on tax return lower borrowing power?

Question

Hey guys,

From what I heard banks normally use your gross income to debt ratio to determine your borrowing power. If I depreciate property value on my tax return to deduct my net income, will that impact my mortgage borrowing power?

Natalie Kolodij · Answer

It actually doesn't impact your borrowing power.

Lenders add back depreciation because they realize it's not an acutal expense/cash outflow on the property.

They add it back in the calculations.

Andrew C. · Answer

Kevin the original question you posed is a very great question and one I learned the hard way a few years ago.  I believe it is an advanced strategy to continually monitor and consider the effect different options have on your DTI as it related to future borrowing power (for conventional loans/financing).

I totally disagree with Eric in the premise that you should always take a deduction regardless of the impact to your DTI ratio that future lenders will  base their lending decisions on.

The other posters were correct in that lenders should Add the depreciation expense back into your final DTI calculation, therefore depreciation expense should NOT affect your DTI ratio.

Having said all that, and where I mainly disagree with Eric’s premise, I believe you are Very smart to consider what effect claiming expenses on your taxes will have on your DTI.  Consider if you had $1200 in maintenance expense for a given year.  If you include that as an expense (write-off) on your taxes, then you have just reduced your net income by $100/month, which WILL have an effect on your DTI ratio.  If you are right on the border to the DTI max, it could make all the difference.

If qualifying for a refinance or another property purchase will likely have a Larger impact on your income and net worth, then perhaps the smart move is to NOT claim a given expense as a tax write-off, and ensure your DTI will qualify you for that refi or purchase.

Real Estate investing comes with great tax advantages, and my premise is that most RE investors with a handfull of properties pay relatively low taxes.  So, if not claiming an expense ($1200/year in example above) on your taxes raises your taxes by $240/Year (20% tax rate), but that keeps your DTI within an acceptable range, that potential refi or new property purchase would only have to net you a savings/income increase of $20+/mo in order for it to pay off.  I’m also guessing that not many investor (who are seeking cashflow) are buying another property for a mere $20/mo cashflow, but are likely netting positive cashflow of several hundred dollars per month per door/property.  So, in that example, choose to pay an extra $240 in taxes (once, and re-evaluate deductions again next year), but gain another property (or refi) that will Net you much more cashflow than $20 per month, seems like the ninja-move to me.  Pay the minimal extra Tax, keep your DTI low (enough) and keep adding to your portfolio.  Reminder: This scenario does not pertain to depreciation versus actual out of pocket expenses due to lenders adding your depreciation back in when calculating your DTI.

Even on a larger scale, with multiple properties, you may get to the point of paying an extra couple thousand on your taxes for a given tax year, but if that allows you to acquire another property that Nets $500/mo indefinitely (gaining $6000/year), isn’t paying $3000 once in extra taxes Well worth the tax expense?

Put another way, if a particular property you wanted to buy had a $240 mandatory fee or the sale would not go through, would that mere one-time fee stop you from the deal?  I would guess not.  Pay the fee/tax, gain the additional property, and add to your net wealth and cashflow - the smart “Ninja-move”.

** Disclaimer: I’m not an accountant or tax attorney and anyone should consult them for any tax or legal advice.

(edited for typo).

Eric James · Answer

Sure, all deductions you take will decrease your taxable income. Lenders will see what you are actually making on a property, not the "cashflow" estimate that didn't include maintenance, vacancy etc.  But I wouldn't recommend you not take legal deductions because you want to increase you income on a loan app.

Kevin Zou · Answer

Thanks Eric! I didn't realize we have to pay recapture when we sell even if we don't depreciate.

Chris Mason · Answer

Depreciation actually HELPS your mortgaged buying power.

The basic depreciation has no impact since it is "added back," but that's true of any/all depreciation. Inclusive of repair/rehab items you otherwise would have listed as a "repair." Every time you shove something OUT of the "repairs" line and INTO the depreciation line, you're increasing your mortgaged buying power.

Talk to your tax professional about what things you MUST write off as a "repair," what things you MUST depreciate, and what things you can pick and choose between. If the goal is to minimize the tax bill this year, you write those optional things off as a repair. If the goal is to maximize your borrowing power next year, you depreciate everything your tax professional says you can depreciate. You have to make a choice between tax bill this year v borrowing power next year. A $7k "repair" write off item might work out to alternatively $1k of "depreciation" write off every year for the next 7 years (still $7k...) -- different things have different depreciation schedules. Longer lasting thing shave longer depreciation schedules, things that need to be replaced all the time have shorter schedules.

Schedule E for reference below.

Linda Weygant · Answer

You are walking a very dangerous tightrope with advocating mortgage fraud.  As with all business expenses, you must report all of your expenses that it takes to create the income.  You don't get to pick and choose which deductions to report or how much.  When you deliberately lower your deductions to artificially inflate your income - and then use that tax return to qualify for a mortgage, you have committed mortgage fraud.

What you can do is make certain elections.

For example, some repairs you can elect to depreciate.  (You can also do the reverse sometimes)

You can also choose not to convert certain personal expenses to business expenses.  For example, if you normally deduct mileage, cell phone or REI club dues, these are personal expenses.  Many people choose to allocate them to their business, but they aren't REQUIRED to do so in the same way that you have to report things like taxes, insurance, mgmt fees, etc.

Brian G. · Answer

@Kevin Zou pretty sure a lender adds the depreciation back in, knowing that is not a true out of pocket expense. Mine does.

Kevin Zou · Answer

Thanks all for the great advises. I am very glad that I asked this question and is very fortunate that I haven't filed my tax returned yet due to COVID-19. I am planning to file my tax in this coming week. You guys are literally saving me around 20k this year from Uncle Sam!!!

Dave Spooner · Answer

@Kevin Zou You've got great answers on your original question above, but I wanted to doubly emphasize a very important side point that has been made:

Depreciation is not optional. The IRS will assume you took it regardless of whether you did or not. You will be required to pay recapture on that assumed depreciation, so you might as well take it when you can!

Basit Siddiqi · Answer

@Kevin ZouMost lenders know to add back depreciation as it is a non-cash expense. This will then result in not hurting your DTI ratio.

Does depreciating house on tax return lower borrowing power?

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