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Tax Talk with George Saenz

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.
Peter

Dear Peter:
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 $150,000.

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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 above.

-- Posted: June 27, 2002

Read more Tax Adviser columns
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See Also
Figuring the tax when you sell rental property
Tax pros and cons of rental property
Residential rental property and capital gains
Tax glossary
More tax adviser stories
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