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?? @Lucas Carl

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

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.

@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.

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.

Making extra mortgage payments has nothing to do with profit or loss. Unless I'm missing something here, it sounds like you simply took your profit and paid down more principal on your mortgage. What you do with said net income is up to you. The goal is to maximize your income/rents, minimize your expenses (while not ignoring repairs, etc), and make sure you take every allowable tax deduction the IRS allows.

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.

@Larry T. 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.

@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.

I've been reading through this and I am not sure what you mean by cancelling taxes out. We all hate paying uncle sam. The nice part about investing in real estate is it is considered a passive income, and therefore is not subject to the 15.3% employment tax, unless of course investing is your principle source of income. What you are experiencing is that uncle sam requires you write-off the capital expense of the property over 27.5 years. So, if your payment structure is not in alignment with 27.5 years, you will either pay more or less than you might think you ought to in any given year. However, it all does come out in the wash eventually. You mentioned not keeping good books. Bad move. That is going to frustrate you and possibly cost you money. Every time you buy a new property, you should make an accurate log of the cost. You can, for the most part, include all expenses that you incur obtaining and fixing up the property, right up to the point you place it in service. After you place it in service, certain items must then be deducted on an annual basis only, and others will need a separate depreciation schedule. That gets annoying, but it is what it is. Again, another reason accurate records are a must. I use a simple spreadsheet to track these, backed up with paper receipts. I keep, or print, a paper receipt for everything. Others trust the digital world. The IRS is not going to care if your computer crashed so, keep that in mind when you decide how to handle that. The first year you own a property, you will need the pre-service total first (up to the point you rent it). That number is your initial cost basis. You will need that number later when you sell. From that number, you will need to subtract the value of the land. That number will be your basis for depreciation. Then add items that were acquired after the property was placed in service that will also be depreciated (and added to your cost basis). Together, with a bit of an adjustment for the timing of it all, will be your first year depreciation deduction. Yes, that is the deduction that represents your mortgage payment, no matter if it is aligned or not. The next year, your depreciation deduction will likely go up a bit, because you will then be claiming the expense for an entire year as opposed to a partial year. You will always need to keep a record of your depreciation from prior years for reference the next year and for reference when you sell. All items you are depreciating, as opposed to taking an annual deduction, count towards your cost basis so, you will need to add those as you go. Then when you sell, you take the total cost basis and subtract all the depreciation expense you took over the years (or, any that you should have, so that's why it's stupid not to) and the difference between that and your sale price (minus the expenses of the sale) will be your capital gain (loss). That'll be $1000 please. The comment that your new CPA took a different depreciation than the prior CPA is troubling. You may need to file an amended return or, maybe that is simply because the prior year was a partial year. If you don't understand any of that, then simply keep an accurate and detailed record of every damn penny you spend and what you spent it on, and all the rental income, and expect a whopping bill from the CPA. Keeping and organizing the income and expenses is by far the most time consuming part of doing taxes, and even more so for a CPA who is not going to immediately know what they are looking at when you hand them a shoe box of receipts. Therefore, if you must use a CPA, at least do that much for them. Have fun and happy April 15th, or March 15th if you have a partner.

@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.

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

Levi T.Pro Member

Rental Property Investor · Tucson AZ / Nice FR / Washington DC · Member since 2016 · 1k+ posts · 1k+ votes

7y

@Chase Cline

Simple answer.. it goes back to the first mistake you made. You paid to much for the property. If you spent $1 to buy and make it market ready, you’d be winning by now. If you paid to much, you’d be losing.

It is that simple, make sure your well below the cashflow line next time.

There are winners and losers in real estate deals, always insure your the winner, by a landslide.

Live and learn, onto the next deal!

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

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