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

[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

[Tim Schroeder]

@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.