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Somehow I always thought rental income is taxable (maybe because I heard that some landlords don't report that income and so the tax board or IRS created the "renter's credit" so the renter will claim the credit and therefore expose the rental income).

But isn't it true like this, say, if a house is $300,000, such as the suburbs of California, Reno Nevada, or Orlando Florida:

  1. If it is paid in cash, then we can't only depreciate it to save tax, so if the time to depreciate is 27.5 years(?), then if the rental income is $1700 per month, then the taxable part is 1700 × 12 - (300,000 / 27.5) = 1700 × 12 - 10909 = 9491, so only $9500 is taxable? But the property tax is about $3000 per year, so only $6500 is taxable?

  2. Plus if we actually pay 20% to 50% down payment, and if the mortgage interest per year is $6,500 or more, then in this case, all the rental income is tax free?

But I think (2) goes down a little bit each year and it reaches $0 at the end of mortgage, and (1) would stop after 27.5 years? And would we just need to sell it and buy another house and depreciate again? Is this how it works?

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  • 4
    You didn't consider selling the rental in your calculation but you should unless you plan to keep the property for a very long time. When you sell, any depreciation you took is subtracted from the purchase price and you will pay tax on the difference between that and the sale price. So for example, if you bought a property for 100,000 and took 10,000 in depreciation and the rental went up by 50,000 when you sold it, you would owe capital gains on 60,000. This means that any "gains" you are avoiding in taxes will eventually get paid when you sell.
    – Kevin H
    Nov 9, 2020 at 19:29
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    This is probably minor but you can only depreciate the cost of the buildings/improvements, not the cost of the land. You wouldn't be able to depreciate on the full 300,000.
    – Kevin H
    Nov 9, 2020 at 19:32
  • @KevinH to be precise, in the United States, you would owe capital gains on 50,000 at your total income determined capital gains rate, and 25% tax on 10,000 as a Section 1250 depreciation recapture
    – user662852
    Nov 9, 2020 at 21:05
  • @user662852 Where are you getting 25% from? IRS publication 544 (Sales and Other Dispositions of Assets) says gains on Section 1250 (and 1245) property are treated as ordinary income, and therefore would be taxed at the ordinary bracket rates.
    – brichins
    Nov 11, 2020 at 0:19

4 Answers 4

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If you had no expenses related to the property as the owner of a rental property: no interest payment on the mortgage, no real estate tax, no condo fee or HOA fee, and no insurance, and no utilities; then yes the entire rental income minus depreciation would be taxable.

But most people who have rental property aren't in that situation. They do have to pay property tax, they do have to pay for insurance, they may have to pay a condo/HOA fee. Some cover utilities. Those reduce the taxable portion of the rental income.

You mention getting a mortgage. But remember that while the interest you pay on the mortgage connected to the rental property, unless you get an interest only mortgage, the part you pay to pay off the principal isn't tax deductible.

You do point out that each year the amount of interest you would pay goes down, but since the monthly mortgage payment is level it means that each year less of that monthly payment is tax deductible.

It is not unusual to see a situation where the monthly costs are around breakeven, or even a slight loss, but on the tax forms the situation looks like it is income producing because of the inability to write-off the principal payment.

Depreciation is a little more complex. It is 27.5 years for the rental house, but you don't depreciate the land. So in your example if mortgage covers the 300,000 value minus 20% down payment; the value being deprecated over those 27.5 years will be less than the 300K value.

When you sell the property because as you said the mortgage is paid off, and the property is full depreciated, then the sale will trigger capital gains taxes and a recapture of the deprecation. So unless the property becomes worthless you will pay tax when you sell.

Getting a mortgage to save on taxes never is cost effective. Getting a mortgage to allow you to purchase a property that will generate income can make sense. Keeping a mortgage on a property that you couldn't sell, and don't have the spare cash to pay off, probably make sense.

Selling a property just so you can depreciate the new one and save on taxes needs further analysis.

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  • and isn't it true when you sell the house, probably after 30 years and it becomes at least $600,000, then you can buy another property say, for $650,000 and then no need to pay the capital gain tax? Nov 9, 2020 at 12:41
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    Depreciation post 1031 exchange is more complex, because you have to account for the deprecation already used on the original property. so the new property won't have a value of $650,000 when you start the new depreciation schedule. Nov 9, 2020 at 13:15
  • "wold" = Would owe? Nov 10, 2020 at 16:21
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You've pretty much nailed it conceptually, but you are implying something which I think should be explicitly called out:

  1. Plus if we actually pay 20% to 50% down payment, and if the mortgage interest per year is $6,500 or more, then in this case, all the rental income is tax free?

Not exactly. You just made the case that there is no rental "profit". You have rental money coming in being completely offset by at least that much in expenses, so your taxable "income" on the property is either $0 or you are taking a loss. In the latter case you don't pay tax; instead you get a tax credit that can possibly reduce your other personal income, or else be carried forward towards future years when you do make a profit.

In other words, the rental income isn't tax free. You aren't paying taxes because you're taking a loss.

3

The depreciation is more of a tax deferment. When you go to sell the property, the basis is reduced by the depreciation you have claimed over the rental period and the IRS will "recapture" the depreciation with a Section 1250 25% tax rate. This is excepted from the personal exemption on primary home capital gains (the situation where capital gains of 250K single or 500k married couple are tax exempt on a home you have lived in for 2 out of 5 years).

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  • tax deferment... and what if the house is passed along as inheritance... I heard the person who inherits it will assume a new cost base, which will be that fair market value, so if the person inherits and sell it, then supposedly there is $0 gain. Nov 9, 2020 at 22:51
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    Just a note, the Section 1250 tax rate is the same as regular income tax rates, but with a maximum of 25%.
    – Craig W
    Nov 10, 2020 at 21:09
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The calculation in point 1 indicates confusion on a significant point. Income is never depreciable; the property is depreciated and that amount is deducted from the income each year (along with expenses like mortgage interest). When the property is sold, the depreciation is recaptured as deferred income and taxed at that time.

As mentioned in another answer, depreciation is only applied to structures, not land. So to walk through your example numbers to see what happens in a given year:

  • Purchase price $300k with 20% down => $240k mortgage @ 3.5% => ~$8,400 interest /yr (early on)
  • Structure value 75%, land 25% => Structure value $225k
  • $225k structure depreciated over 27.5 yrs => ~$8,180 annual depreciation
  • Property tax $3000 / year
  • Income $1700 /mo = $20,400 / year

Net income is income less expenses:

20,400 rent - 8400 interest - 3000 tax - 8180 depreciation = $820 net income

And there would actually be more expenses in the form of car mileage, loan closing costs, repairs, etc etc. So yes, it's entirely plausible for this scenario to have no net annual income on paper, or even a loss, while actually pocketing ~$9k (likely as equity as this example ignores the principal payments), for the next 27 years.

But, say this house is sold in 5 years, with no appreciation in value to keep it simple.

  • Sale price $300k
  • Depreciation of 5 years * 8180 /yr) = $41,900
  • Cost Basis 300,000 - 41,900 = $259,100

This results in a capital gain of 300,000 - 259,100 = $41,900 net gain (ignoring principal/equity from the down/monthly payments as that's just recovery of basis). This amount is taxable at the normal rate for that bracket (10-12% assuming no other income), capped at 25% for the highest brackets.

In later years, the basis will have decreased so much that the net gain would start to approach the entire value of the property, and the tax burden would increase proportionately.

Now if there were capital gains from appreciation in value, some or all of that would be tax free. For 2020, the 0% capital gains tax bracket cutoff is $80,000 - that is, the first $80k is not assessed any capital gains tax. So if the property sold for $380k, the extra $80k could be tax free (subject to total income limits).

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  • The $41,900 recaptured depreciation is taxed at 25%. Nov 10, 2020 at 23:29
  • @mhoran_psprep No, it is at the normal income rate per IRS Pub 544, Section 1245 Property: "Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property." Same language for Section 1245 property, though there are some complicated rules about edge cases later on.
    – brichins
    Nov 11, 2020 at 0:05

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