Is there a max on mortgage interest you can write off taxes?

Question

I'd like to find out if there is a maximum amount of mortage interest that one is allowed to write off of income taxes in any given year.

I'm a newbie and here's my situation:

I'm a farily new lawyer (48 yrs old, unmarried, no kids, no property) on my second career having worked as an engineer for a major corp. for the last 20 years. I used a lot of my savings putting myself through law school finishing 5 years ago, passed the bar and have been working as a patent attorney for the last 5 years. I've paid off all my high interest (9-15%) student loans in that time and now just have a 5% loan on the remaining student loan. Payments are only $350/month so I'm paying that off slowly.

My salary is sarting to creep up to the point where income taxes are a concern as I have no write-offs at all. I've owned two properties in Orange County in the past - the first home, a fixer, was bought in 1988 and sold in 1989. The 2nd home I bought in 1990 at the peak, held it for 4 years, renting it out, then got tired of the constant negative cash flow and finally selling it for less than I paid for it.
I have some experience in real estate investing but have held off buying another property after losing $$ on my last home.

I'm now at a point where I can invest in real estate again but becuase of the steep prices in Southern California, the flat market and because I don't want to put all my eggs in 1 basket, I want to invest in one or several rental homes out of state.

My questions are - is there a maximum amount of interest and property taxes that you can write off your taxes in any one year? Is there a cap on how much you depreciation you can write off in any one year if you have several rental properties? Any other considerations or pitfalls for investing in numerous rental properties?

Thanks for any advice.

Joe Wilson · Answer

Well, buying property in different markets around the country will not spread the risk or diversify your holdings. It is like buying COKE and PEPSI in the stock market and saying "I'm diversified!" You will probably buy several of the same type of investment homes within a market segment but in different geological markets and that is fine because that may reduce some, albeit small, market risk. I don't think that is a significant point to ponder on though.

You have several different markets within one geological market and that is Student housing, Section 8, Class A-D apartment buildings, condos and rental homes in different parts of cities are almost their own market.

I bought 6 condos in a university setting. I felt that was a good market because people are always going to college and I have had very good occupancy rates. I have a management company handle it in the town.

I have two other homes; one in the country and one in a suburb neighborhood. They have done well too.

You want to figure out the Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). Take EBITDA and divide by purchase price. This will give you a percentage called Cap Rate. The higher the better and you'll find that it is usually around 6-7% or should be. Look around, you may find better investments.

There are too many questions to answer in just this one entry, but research here will help you understand in due time what is best for you.

Now dealing with taxes. You are not a RE professional so you will be eligible to be able to deduct up to $25,000 of passive RE losses against your non-passive income. When you get over $150K AGI, then this is taken away.

You may be well suited to have an LLC own the property and pass the income (or paper loss) via a K-1.

You should end up with a positive cash flow, but an ordinary loss on paper (and your tax return)! When you decide to sell it, that will be a capital gain and your savings from that alone is about 15% in taxes. (ordinary vs. capital)

Ask more questions, you've got a lot to learn, but it is a great investment.

Sean O. · Answer

John: Thanks for your additional comments. Regarding your tangent question, I'm a patent attorney and work in an Intellectual Property firm with 12 other patent attorneys.

The properties I'm thinking of investing in are newly built near a large metro area and would generate a neutral or even slightly positive cash flow even before taxes (i.e., before writing off interest, prop. taxes and considering depreciation). With vacancy rate of 10% and considering maintenance and property mgt. costs my calcs still show a positive cash flow. My goal over the next ten years is to purchase individual rental homes in several different markets around the country to spread the risk and build equity.

I haven't run any numbers under an AMT scenario but thanks for mentioning that point which I wasn't aware of. Nor have I run numbers on the tax consequences of rental income. For example, 4 homes generating $1000 ave. monthly rents will result in almost $50k in passive income. What are the tax implications?

Thanks.

Sean

Account Closed · Answer

A slightly different view.

As All Cash points out the interest write off means you spend money and you get a bit back. It is not a great way to shelter income from your legal work.

Better is the paper losses that can happen from the depreciation. In that case you could have losses on paper that offset some of your income from non-RE activities. Hence you could truly reduce your tax bill while still having an income. The paper losses from depreciation will be recaptured when you sell if the price achieved is higher than the tax basis of the property.

There is a different angle. From your legal work and your investing you may be operating a business that will allow you to cover some expenses as a business expense. Things that would have occurred in any event but now are deductible if you operate company (legally and following the tax regulations). You also can look at the pension contributions and other ways to defer income in a tax efficient way.

At some level paying taxes means you have income or profits. It is a sign that you are doing better than those who pay little in tax because they have little in income. Focus on doing smart deals and not on maximizing the tax deductions. No need to over pay but still focus generating profits.

As a tangent, what sort of law are you practicing now?

Having a number of rental properties can make for a management challenge depending on how you are organized. It does not really change the tax angle.

Note that AMT kicks in when you have an income above specific levels. Hence your ability to write things off in a tax year can be compromised by your income level even if everything else lines up. In effect you have to calculate your taxes two different ways (normal process and then the AMT process). AMT removes a number of normal deductions.

John Corey

Frank Adams · Answer

puffydog wrote;

Interest is a legitimate business expense, in any business. Expenses can always be written off. If you borrow money to buy new lawbooks both the books and the interest are leigitimate expenses. In my experience people who concentrate on the "write offs" have never been in business for themselves.

I used to look at my $400 month phone bill, $700/month hotel, 50,000 miles a year on a car (killer of profit for people who think the "write off" is a good idea), and worry a lot more about reducing the expenses than about the tax write off.

I'd rather have the income and pay the taxes.

Again you're buying quarters for a dollar apiece, terrible purchase!

all cash

Sean O. · Answer

Thanks for your advice. I uderstand about the write off not being a tax credit. I'm looking for ways to reduce income tax and as far as I know, real estate is the only investment where you can write off interest.

Frank Adams · Answer

IMO you're looking at the problem from the wrong side. Paying more taxes @ any marginal rate is not as high as interest expense at 100%. Interest wtire off is a reduction of income, not a tax credit.

AFAIK there is no limit on the interest or ppty tax write off on investment property as opposed to owner occupied where I believe the limit is interest on the first million borrowed. That figure may have been inflation adjust by now.

There is a limit on the amount of expenses you can write off if you are a "passive investor", which you would be if you're investing out of state.

Since you're going to have a property manager you'll want to make sure that the property is throwing off lots of income in order to handle the mangement expense.

Don't worry about paying more taxes. Just make more money!

all cash

Is there a max on mortgage interest you can write off taxes?

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