Is it true that rental income may end up not taxable in USA?

Question

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?

Answer 1

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.

Answer 2

You've pretty much nailed it conceptually, but you are implying something which I think should be explicitly called out:

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?

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.

Answer 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).

Answer 4

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).