Deducting Interest on Rental Property

Find out a landlord’s most common deductible interest payments.

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. The interest payments Ken makes on the loan are deductible.

There are certain rules that apply to deducting interest on loans used to purchase or improve a rental property. (Learn more about the many tax deductions to rental property owners.)

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.

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
  • surveys
  • 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).

Interest on Construction Loans

If you borrow money to construct a rental property, you may currently deduct as an operating expense the interest you pay before construction begins and after it ends. However, you may not deduct the interest you pay during the construction period. Instead, this cost must be added to the basis of your property and depreciated over 27.5 years. (I.R.C. § 263A(f)(1).)

Loans on Rental Property Used for Nonrental Purposes

You can take out a loan secured by your rental property and use the proceeds for nonrental purposes. If you do this, you can’t deduct interest you pay on the loan as a rental expense. Whether it is deductible at all, and to what extent, depends on what you use the money for:

  • Personal purposes. You get no deduction if you use the loan proceeds to buy something for your personal use—for example, you take a vacation or buy new appliances for your residence. Personal interest is not deductible, except for interest paid certain home mortgage interest and interest on student loans.
  • Investment purposes. You may get a deduction if you use the loan for investment purposes—for example, to purchase stocks or bonds or some other investment. You can deduct investment interest as an itemized personal. However, you can deduct investment interest only from investment income. Thus, if you have no investment income, you get no deduction. If your interest expense exceeds your investment income, you cannot deduct the overage. You must carry it forward to deduct in a future year when you have enough investment income.
  • Business purposes. You can deduct the interest if you use the loan proceeds for a business other than renting residential property—for example, a landlord borrows money on his rental property to purchase equipment for his construction business. You can fully deduct business interest as a business expense in the year in which it is paid.

Limitation on Interest Deductions by Landlords Earning $25 Million or More

Starting in 2018, all businesses with average gross receipts of $25 million or more over the prior three years can deduct interest payments only up to 30% of their adjusted taxable income. (IRC § 163(j).) This limitation applies to landlords who earn this much income from their rental business. Landlords (and other real property businesses) who earn $25 million and more can get out of this prohibition, and thereby deduct 100% of their interest expenses each year, by filing an election with their tax return (which is irrevocable). Thereafter, they must depreciate their real property for longer periods.

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