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I own a rental property outright (no mortgage). We will most likely hire an accountant for at least our first year of doing this, but I wasn't planning on doing this until tax time. I am new to the rental thing and just started giving some thought to taxes. I had the thought that since I have no mortgage payment that I will certainly show a sizeable profit from the rental. I'm not sure this is a good thing.

Would it make more sense to finance the rental property? Would this mean that I could deduct the mortgage payments or would it be just the interest?

Are there other deductions that I'm not aware of that would be more beneficial than a mortgage payment (ie. some sort of depreciation deduction)?

UPDATE (2014-10-23)

It turns out that I wouldn't get to deduct any mortgage payments by taking out a loan, which I originally thought might be considered a business expense. However, I do get to depreciate the home each year. I also get a straight deduction on repairs. So it has turned out that we get a decent increase in income that only shows up as a modest increase to my overall taxes. Since we've been lucky and have been able to keep the house rented it has been a really wise move to keep the house as a rental. Its value has gone up about 30% since I asked this question. So I could sell at a profit but it doesn't make sense because the income from rent results in a far higher income than I could get by putting the sale money somewhere and just collecting interest. I'm guessing we are ahead by 9 to 10 percent per year by renting out versus putting the money in savings.

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    Your questions invite the inference that you are not prepared at all to enter into the business of being a landlord. I strongly recommend reading a couple of books, hiring an accountant (to help you understand the cash flow and tax aspects of the rental business) and a lawyer (for drafting leases, rental agreements etc) first before renting anything to anybody. Waiting until tax time is far too late to be doing this. Also, I am voting to close this question as far too broad to be answerable properly in this forum. – Dilip Sarwate Aug 1 '12 at 18:27
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    Talk to tax person before you do anything. Very hard to change what's done. tax person is not a magician, he can only help you describe what you've done to the tax authorities. Also, talk to a lawyer and an insurance agent. – littleadv Aug 1 '12 at 19:03
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    If after expenses, the profit is "sizeable" isn't that a good thing? Better than the opposite. – JoeTaxpayer Aug 1 '12 at 21:02
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    This is a good question and shouldn't be closed. Refine the question and answer it. This is a good question because it is a difficult subject, and the experts here can help refine the issues so seeking out an accountant is more productive. This question should spawn many more. – MrChrister Aug 1 '12 at 23:23
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    Note that this question is roughly equivalent to "Should I get a business loan, or should I make the investment to start my business out of my savings" -- and the answer is tied to what kinds of risk you can afford and/or prefer. – keshlam Oct 20 '14 at 12:39
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To answer some parts of the question which are answerable as-is:

  • Yes, mortgage interest is deductible. So is depreciation. See this question and others.

  • It would be a good idea to put some money away for tax season, just as you should save some money to cover unexpected property expenses. But as @JoeTaxpayer says, this is a good problem to have, assuming you own the property, it's low-maintenance, your tenant is good, and your rent is at market levels.

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    It might be even better idea to pay estimate taxes during the year and not to wait till the tax season when you can get get slapped with underpayment penalties. – littleadv Aug 1 '12 at 22:48
  • Doesn't a deduction for depreciation require active participation in the rental activity? Else there can be passive losses that are not deductible currently but are settled when the property is sold. – Dilip Sarwate Aug 2 '12 at 2:15
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    The depreciation is not optional, whether one can take losses against ordinary income depends on active participation and AGI. If it can't be taken, it accrues until it can be applied against profits, taken against income (if under AGI limit) or taken when the property is sold. – JoeTaxpayer Aug 2 '12 at 2:22
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In general you do not want to show a taxable gain on rental properties if you can avoid it. One of the more beneficial advantages of owning cash flowing rental properties, is that the income is tax deferred because of the depreciation. I say deferred, because depreciation affects the cost basis of your property.

Also since you are considering financing, it sounds like you don't need the cash flow currently. You usually can get better returns by financing and buying more rental properties, especially with investment mortgages at historical lows (Win via inflation over time)

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