As a general rule, you may deduct interest on money you borrow for a business or investment activity, including being a landlord. A landlord’s most common deductible interest payments are:
- mortgage interest payments to banks and other financial institutions on loans used to acquire rental property
- mortgage interest payments to financial institutions on loans used to improve rental property
- interest on credit cards for goods or services used in a rental activity, and
- personal loans for any item used in a rental activity.
Remember that you only deduct the interest you pay on a loan to purchase or improve a rental property. You may not deduct payments of principal—that is, your repayments of the amount you borrowed. The principal is ordinarily added to the basis of your property and depreciated over 27.5 years.
Example: Ken takes out a $10,000 second mortgage on his rental house to remodel the kitchen. This is a home improvement loan. The $10,000 loan amount is not deductible. Instead, it is added to Ken’s basis in the home and depreciated over 27.5 years.
There are certain rules that apply to deducting interest on loans used to purchase or improve a rental property.
Interest on Loan Proceeds Kept in the Bank
You get no rental deduction for interest you pay on loan proceeds that you keep in the bank. Your rental interest deduction begins only when you spend the money on your rental activity. Money kept in the bank is considered an investment—at best you might be able to deduct the interest you pay on the money as investment interest.
Interest on Money You Don’t Legally Owe
You may only deduct interest for money you legally owe. If you are liable for part of a debt, you can deduct only your share of the total interest paid or accrued.
Example: Sandra and her daughter, Sally, purchase a rental house together. Both their names are on the deed, but only Sally’s name is on the mortgage. Because Sandra is not legally liable for the mortgage, she cannot deduct any interest she pays on it; only Sally gets this deduction.
Interest Paid Through a Second Loan
You cannot deduct interest you pay with funds borrowed from the original lender through a second loan, an advance, or any other arrangement similar to a loan. You can deduct the interest expense once you start making payments on the new loan. When you make a payment on the new loan, you first apply the payment to interest and then to the principal.
Example: Phil obtains a $20,000 high-interest, short-term loan from the Acme Finance Company to pay for repairs to get his aged rental building up to code and avoid a condemnation. Phil is personally liable for the loan. He falls behind in his loan payments. To avoid having Acme take his bank accounts or personal property, he obtains a second loan from Acme for $5,000, secured by his own house. He uses the second loan to pay $5,000 in overdue payments on his original loan from Acme. The $5,000 payment, which is almost all for interest charges, is not a deductible interest payment. Six months later, Phil pays back the $5,000 loan with interest. He can deduct the interest he pays on this loan.
Interest on Income Tax
Interest charged on income tax assessed on your individual income tax return is not deductible even though the tax due is related to income from your rental activity.
Expenses to Obtain a Mortgage
You can’t deduct as interest any expenses you pay to obtain a mortgage on your rental property. Instead, these expenses are added to your basis in the property and depreciated along with the property itself. These basis adjustments include:
- abstract fees
- charges for installing utility services
- legal fees
- mortgage commissions
- recording fees
- transfer taxes
- title insurance, and
- any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commission.
For detailed guidance on how to deduct interest on rental properties, see Every Landlord's Tax Guide, by Stephen Fishman (Nolo).