Ask the tax adviser
Finance or pay cash for rental property?
Dear Tax Talk:
My wife and I will be purchasing a residential
rental property soon. Is it to our tax advantage to finance this
purchase or pay cash? If we finance, can we deduct the interest
payments on a rental property? Thank you for your time.
From a tax standpoint as well as an investment point of
view, it is probably wiser to finance the property since the interest
on the debt is deductible against the income from the property.
Your goal here would be to generate enough deductions
against the income of the property so that you break even every
year, especially if your adjusted gross income exceeds $150,000.
Losses from rental real estate are not deductible against other
items of income when your adjusted gross income is greater than
You have to figure the break-even point by budgeting
other expenditures, including depreciation allowance, in relation
to the income. Then you would back into your loan amount by estimating
the amount of interest expense needed to offset remaining profit.
Suppose you want to buy a home worth $100,000 that
you expect to rent out at one percent of value per month (a good
rule of thumb) or $12,000 a year. The estimated land value is $10,000,
which is not depreciable.
Residential rental property is depreciated on a straight-line
basis over 27.5 years or 3.6 percent a year; that means 1/27.5 of
$90,000 is around $3,200 a year in depreciation. Taxes, insurance
and other expenses are $3,800 a year. This would leave you a profit
of $5,000. If you can borrow at 7 percent, $5,000 divided by 7 percent
is $71,400, which is where you should target your mortgage.
You should be positive from a cash standpoint since
your principal payments would be less than $3,200 in depreciation
allowance. From an investment standpoint, say the property appreciates
5 percent a year or $5,000 a year. In six years, that's $30,000
earned on a $30,000 investment (cost of $100,000 less approximately
$70,000 borrowed), which is a 12-percent rate of return.
It gets better if you do a 15-year mortgage. In this
case, at the end of six years, the tax-free rental income has paid
off approximately $20,000 of the principal on the mortgage outlined
-- Posted: June 27, 2002