Rentals Taxed on Net Income Which Doesn't Include Mortgage?

Rentals Taxed on Net Income Which Doesn't Include Mortgage?

Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes

Hi Everyone - I have 3 STRs and have gotten very serious with looking at the full financial picture on them now that we have a CPA. We just bought the last two in the last 6 months, but have had our first for almost 5 years now. We were very nonchalant with the numbers on the first one cause we always assumed we were doing well since it was renting great (bad assumption, always know your numbers! very big rookie mistake). 

Anyway, signed up for quickbooks and for 2018 we ended up basically breaking even with revenue v. expenses.  In my mind, I was thinking well at least we won't owe any income taxes on it, WRONG!  Turns out you aren't taxed on profit, you are taxed on net income which doesn't include mortgage payments. Meaning if we broke even with $0 profit but paid $10k in mortgage payments, we are taxed on $10k net income as if the mortgage payments weren't expenses. I know this is a very rookie mistake on our part, but that seems crazy to me!

I made $0 in profit but still owe thousands in taxes. Even if I made $10k in profit and paid $10k in mortgage payments, I would be taxed as if I made $20k profit. It makes the appeal of doing rentals at all not that great.

Let's say I buy a place for $200k and it generates $50k in revenue. Let's assume $20k profit and $20k mortgage payments.  I am going to be paying taxes on $40k which will be at least $8k. So with the $20k profit minus $8k in taxes, I'm really only getting $12k cash in my pocket after the tax year. That's only a 6% return on the purchase price. How do you get around this? It's kind of taken the wind out of my sails to be honest... How can you get better numbers??

@Luke Carl

0Reply
123 views

Most Popular Reply

Rental Property Investor · Castle Rock, CO · Member since 2017 · 335 posts · 387 votes
7y

@Chase Cline

Meaning if we broke even with $0 profit but paid $10k in mortgage payments, we are taxed on $10k net income as if the mortgage payments weren't expenses

What you're missing is that mortgage payments are two things (four if your insurance and taxes are escrowed). 1) Principal: You're paying back the bank loan and adding equity, 2) Interest: An expense incurred in obtaining the loan, 3) Insurance: An expense incurred in holding a valuable property that you want protected, 4) Taxes: An expense incurred in property ownership.

Remember that the principal payments add to your equity. You'll get that money back someday when you sell it. Therefore, you can't claim it as an expense.

See this reply in the discussion

87 Replies

Jump to latestLatest
  • Real Estate Agent · Sevierville, TN · Member since 2015 · 1k+ posts · 1k+ votes
    7y

    Your mortgage interest should be tax deductible.  Your mortgage principal is not.  If your CPA is telling you that you can't deduct your mortgage interest, get a second opinion.

  • Jennifer T.Pro Member
    Investor · New Orleans, LA · Member since 2014 · 1k+ posts · 944 votes
    7y

    I came to that unfortunate realization this year also, lol.  I guess it makes sense from an IRS perspective because you're essentially trading X dollars for X value in real estate.  I would think other business purchases, no matter the industry, work that way also.  But then, depreciation can be an expense.  Depending on what your CPA recommends.  And mortgage interest is definitely an expense. 

  • Rental Property Investor · Castle Rock, CO · Member since 2017 · 335 posts · 387 votes
    7y

    @Chase Cline

    Meaning if we broke even with $0 profit but paid $10k in mortgage payments, we are taxed on $10k net income as if the mortgage payments weren't expenses

    What you're missing is that mortgage payments are two things (four if your insurance and taxes are escrowed). 1) Principal: You're paying back the bank loan and adding equity, 2) Interest: An expense incurred in obtaining the loan, 3) Insurance: An expense incurred in holding a valuable property that you want protected, 4) Taxes: An expense incurred in property ownership.

    Remember that the principal payments add to your equity. You'll get that money back someday when you sell it. Therefore, you can't claim it as an expense.

  • Rental Property Investor · Clarksville, TN · Member since 2016 · 1k+ posts · 1k+ votes
    7y

    @Chase Cline

    Hi Chase,

    The income from your rentals doesn't seem like it's being reported in the correct place, or you are not claiming nearly enough expenses. If you look up IRS form schedule E, you'll see that advertising, auto and travel, cleaning and maintenance, commissions, insurance, legal and other professional fees, management fees, mortgage interest, other interest, repairs, supplies, taxes, utilities, depreciation all get deducted from your rental income before it flows through to your taxable income.

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y
    Originally posted by @Julie McCoy:

    Your mortgage interest should be tax deductible.  Your mortgage principal is not.  If your CPA is telling you that you can't deduct your mortgage interest, get a second opinion.

     Mortgage interest, yes definitely.  Not the actual principal though. We were making double mortgage payments for like 8 months last year so we ended up showing like $13k in net income even though we broke even.  Just doesn't seem right.  Even making a thousand bucks profit a month you'd end up paying taxes on $25k even though your real profit was $12k. So you'd pay like $6k in taxes and only truly make $6k from a VERY good profit per month property. Seems like a waste! Am I missing something?  

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Tim Schroeder yea I get that, but still, hoping to make a few grand a year for a payout 30 years down the road doesn't seem worth it...

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Todd Rasmussen yea we reported all of that. We have a dedicated bank account that pays for all the expenses for this property in question. Our expenses are huge (HOA, property tax, cleaning fees, 15% hotel tax). We generated $30k in revenue but somehow after all of those items ended up with like $29.5k in cost. Very frustrating. And THEN we now owe a few grand in taxes as if we made a profit..... taxes on taxes on taxes on taxes...

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Todd Rasmussen great catch on the depreciation though... I have a feeling she forgot to include the updated depreciation in our expenses! That will basically eliminate all the net income... gonna call her now. thanks!

  • Rental Property Investor · Clarksville, TN · Member since 2016 · 1k+ posts · 1k+ votes
    7y

    @Chase Cline

    Good luck! The only other thing I can think of is maybe it's being claimed as business income and flowing through schedule C which might explain additional taxes?

  • Rental Property Investor · Castle Rock, CO · Member since 2017 · 335 posts · 387 votes
    7y

    @Chase Cline Let's say I buy a place for $200k and it generates $50k in revenue. Let's assume $20k profit and $20k mortgage payments. I am going to be paying taxes on $40k which will be at least $8k. So with the $20k profit minus $8k in taxes, I'm really only getting $12k cash in my pocket after the tax year. That's only a 6% return on the purchase price.

    You're looking at this wrong. ROI analysis is pre-tax. Just like when you look at mutual fund returns, it's pre-tax. When you get a job, your salary is pre-tax. When you win the lottery, it's pre-tax. In your example above, the ROI is 10% (20k/200k) on which you will pay some amount of tax. Just like you pay on mutual funds, salary, or lottery winnings.

  • Flipper/Rehabber · Rochester, NY · Member since 2014 · 1k+ posts · 1k+ votes
    7y
    Originally posted by @Chase Cline:
    Originally posted by @Julie McCoy:

    Your mortgage interest should be tax deductible.  Your mortgage principal is not.  If your CPA is telling you that you can't deduct your mortgage interest, get a second opinion.

     Mortgage interest, yes definitely.  Not the actual principal though. We were making double mortgage payments for like 8 months last year so we ended up showing like $13k in net income even though we broke even.  Just doesn't seem right.  Even making a thousand bucks profit a month you'd end up paying taxes on $25k even though your real profit was $12k. So you'd pay like $6k in taxes and only truly make $6k from a VERY good profit per month property. Seems like a waste! Am I missing something?  

    You are confusing profit and cash flow.  If you paid off your entire mortgage off your cash flow would go down by that amount, got it? It’s not in your bank account anymore. But that doesn’t mean you lost money.

    This is something people often forget when they decide to aggressively pay off a mortgage.  It doesn’t lower your taxes at all. In fact, since you’ll be paying less interest it will increase your taxes. So your cash flow will be negatively affected (pay down and more taxes) until the entire mortgage is paid off.  You’ll still be paying more taxes after it is paid off but since you won’t have a mortgage your cash flow will be higher. 

    Moral of the story?  Don’t aggressively pay down your mortgage. 

  • Rental Property Investor · Castle Rock, CO · Member since 2017 · 335 posts · 387 votes
    7y
    Originally posted by @Chase Cline:

    @Todd Rasmussen great catch on the depreciation though... I have a feeling she forgot to include the updated depreciation in our expenses! That will basically eliminate all the net income... gonna call her now. thanks!

     Your CPA "forgot" to include depreciation???!?!?!?!?

  • Rental Property Investor · Castle Rock, CO · Member since 2017 · 335 posts · 387 votes
    7y
    Originally posted by @Larry Turowski:
    Originally posted by @Chase Cline:

    Moral of the story?  Don’t aggressively pay down your mortgage. 

     PLUS, you could use that extra money to fund another property :)

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Todd Rasmussen so what are the financials supposed to look like in an ideal world?  Where you actually make lets say $1k profit/month, but then depreciation wipes it all out so to the IRS it looks like you didn't make any money so you get to keep the full profit? 

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Tim Schroeder Ha no, she included it, but it was on a lower amount that was calculated from a previous tax guy at H&R Block for about 1/3 of what it should've been. We mentioned the new value amount but I dont remember her writing it down so I think it was missed. 

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Tim Schroeder well looking at it pre-tax is missing a huge portion of the full picture. What's the point in looking at a pre-tax $10k profit when you're gonna owe $10k in taxes. You didn't actually make any money so why have that investment? I want to know cash in my pocket after taxes

  • Real Estate Agent · Sevierville, TN · Member since 2015 · 1k+ posts · 1k+ votes
    7y

    @Larry Turowski is correct.  You cannot - ever - write off principal payments.  You're buying an asset with that money!  It's not an expense.  Interest, however, is an expense, and deductible.  

    How paying off a mortgage affects cash flow - obv while you're making higher payments, it negatively affects your cash flow, because you're putting that cash towards the mortgage.  Once the mortgage is paid off, all the money that you were spending on the mortgage goes to cash flow.  Great, right?  Except, like Larry said, then you can't write off the interest because there is no interest, so it's a bigger tax hit.  And you have more capital tied up in the asset, instead of available to use on other investments.  Whether this is a pro or con depends on your point of view and goals - there are endless debates on the topic all over BP.

    If your CPA didn't take depreciation into account, fire her and hire a new one, as she clearly knows nothing about real estate.

  • Developer · Cincinnati, OH · Member since 2018 · 1k+ posts · 3k+ votes
    7y
    Originally posted by @Chase Cline:

    Hi Everyone - I have 3 STRs and have gotten very serious with looking at the full financial picture on them now that we have a CPA. We just bought the last two in the last 6 months, but have had our first for almost 5 years now. We were very nonchalant with the numbers on the first one cause we always assumed we were doing well since it was renting great (bad assumption, always know your numbers! very big rookie mistake). 

    Anyway, signed up for quickbooks and for 2018 we ended up basically breaking even with revenue v. expenses.  In my mind, I was thinking well at least we won't owe any income taxes on it, WRONG!  Turns out you aren't taxed on profit, you are taxed on net income which doesn't include mortgage payments. Meaning if we broke even with $0 profit but paid $10k in mortgage payments, we are taxed on $10k net income as if the mortgage payments weren't expenses. I know this is a very rookie mistake on our part, but that seems crazy to me!

    I made $0 in profit but still owe thousands in taxes. Even if I made $10k in profit and paid $10k in mortgage payments, I would be taxed as if I made $20k profit. It makes the appeal of doing rentals at all not that great.

    Let's say I buy a place for $200k and it generates $50k in revenue. Let's assume $20k profit and $20k mortgage payments.  I am going to be paying taxes on $40k which will be at least $8k. So with the $20k profit minus $8k in taxes, I'm really only getting $12k cash in my pocket after the tax year. That's only a 6% return on the purchase price. How do you get around this? It's kind of taken the wind out of my sails to be honest... How can you get better numbers??

    @Luke Carl

    Fire your CPA.

    The interest payments on your mortgage can be deducted against your rental income.

  • Rental Property Investor · Douglas County, MO · Member since 2014 · 1k+ posts · 1k+ votes
    7y
    Originally posted by @Chase Cline:

    @Tim Schroeder Ha no, she included it, but it was on a lower amount that was calculated from a previous tax guy at H&R Block for about 1/3 of what it should've been. We mentioned the new value amount but I dont remember her writing it down so I think it was missed. 

     How can you have a "new value amount"? Unless you did something like put on a new roof, or build an addition, or something else that needs to be capitalized, your basis is your basis and you can't just change it.

  • Rental Property Investor · Clarksville, TN · Member since 2016 · 1k+ posts · 1k+ votes
    7y

    @Chase Cline

    Speaking in huge generalities about passive investors that are non real estate professionals (ie have a normal source of income from a w2 or non real estate self employment) and without being a tax professional:

    Yes. I wouldn't exactly word it like that, but you get to legally deduct so many expenses related to real estate investing that huge portions of your gross income should be offset by deductions. Limited experience, but have found Sch E line 26 (total rental real estate income) showed less than 20% of gross rents received on our least expensed (that's a word now) property in the past two years.

    Speaking to your specific example, if you have 1k of "profit" a month and depreciation wipes it out, then you did not make any taxable income from your rental real estate activities and actually made "0" profit a month according for the IRS. The 12k in your bank account is just not taxed yet. When you go to sell the property, you will pay tax on the "profit" the IRS "didn't tax" through depreciation recapture. Uncle Sam finds a way to always get his.

  • Rental Property Investor · Castle Rock, CO · Member since 2017 · 335 posts · 387 votes
    7y
    Originally posted by @Chase Cline:

    @Tim Schroeder well looking at it pre-tax is missing a huge portion of the full picture. What's the point in looking at a pre-tax $10k profit when you're gonna owe $10k in taxes. You didn't actually make any money so why have that investment? I want to know cash in my pocket after taxes

    If your pre-tax profit is 10k, then you'll pay (for example), 2k in taxes so you made a profit of 8k. There is never a case in which you made a 10k profit and paid 10k in taxes. I think what you're doing is including your mortgage payments when calculating your "profit" which is incorrect. Calculate your profit excluding the principal payments. In your case you may find that number is negative.

    If that's the case, sell it now while it's a seller's market and either look for something better-performing, or hold your cash until there is a market downturn.

  • New York City, NY · Member since 2016 · 470 posts · 348 votes
    7y
  • Real Estate Consultant · Cleveland, OH · Member since 2016 · 511 posts · 345 votes
    7y

     If you are planning on holding a rental for 30 years you got bigger losses coming your way...

  • Rental Property Investor · Ankeny, IA · Member since 2017 · 2k+ posts · 3k+ votes
    7y

    @Jennifer T.  "depreciation can be an expense. Depending on what your CPA recommends"....

    Ummmmmm.....the IRS assumes depreciation, whether you take it or not. In other words, when you sell, you have to recapture the depreciation, whether you took it or not. If your CPA is not "recommending" you take depreciation, find a new CPA. Now, I'm no CPA, but if you keep your property until death and then pass it down to your heirs, it is also a huge tax advantage. 

  • Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
    7y

    @Michael Ealy yes, mortgage interest was deducted as was depreciation. Still showing a $4,500 profit to the IRS even though we broke even. Again, we were making double mortgage payments for like 6 months so that would've changed things. Just trying to figure out what is a great performing STR?

Join the conversationCreate a free account to reply, vote on answers and follow this thread.