Ultra-basic tax example

[Michael G]

Hello friends,

As I get closer to buying my first rental unit, I am thinking more about taxes. I know depreciation can be used to offset rental income. I have a few questions about what the government considers income, and what can be deducted from that income.

I think I can deduct things like:
Property taxes
Maintenance fees
Mortgage interest
Depreciation

I am not sure if I can deduct:
Repayment of mortgage principle

I believe rent paid to me is taxable income, and then I deduct the above items from that. Can I deduct the mortgage payments I make? If I am planning to use the profit to buy another unit, do I still have to pay taxes on it?

I think since I am trading that money for an asset that it will be taxed... I just want to make sure.

Thanks everyone.

[Jon Holdman]

Principle is not deductible. Its cash out the door, but its really just a transfer from one asset (your bank account) to another (your equity in the property). You can deduct the mortgage interest only.

Your net taxable income is the rent you actually collect less all expenses and less depreciation. Much of what you spend after the property is "rent ready" is expense. Taxes, HOA fees, interest, insurance, cleaning, repairs, lawn care, legal fees, CPA fees, etc. The property itself must be depreciated over 27.5 years. So, you can deduct 1/27.5 of the value of the improvement (not land) each year. Some other items, like roof, flooring and appliances are also "capital". These are also depreciated, though there are different timelines for different items. Also, the money you spend after you buy but before its rent ready adds to the basis and is not expense, even if the item would have been expense after it was rent ready.

A profitable rental will have a positive taxable income. That's taxed at your ordinary tax rate. Unprofitable rentals often produce "passive losses". If your AGI is under $100K, you can use this to offset other income, up to $25K. Over $150K, you cannot. In between the $25K "special allowance" phases out, $1 for every $2 of income over $100K.

Also, as you take depreciation (or, even if you don't), the "basis" for the property is reduced by the depreciation. When you sell, your gain on the sale is based on your basis, not the original purchase price. Further, there's a different tax on the unrecaptured depreciation. For example, say you buy a house for $100K. $80K is the value of the improvements. You sell after 13.75 years. You will have taken $40K of depreciation, so your basis is now $60K. You sell for $150K. That gives you a gain of $90K. Of that $40K is subject to the tax on unrecaptured depreciation. Currently, that's 25%. The remaining $50K in gain is subject to long term capital gains tax, currently 15%.

What you use the profits for is irrelevant as far as taxes.

A CPA is, IMHO, essential if you own rentals.