Maybe you’ve got an extra room in your home that you’re renting out for a relief on the bills. Or maybe you’ve just moved in with your significant other, and you’re renting out your bachelor pad before selling it. But beware: if there’s still a mortgage on the property, you may think you don’t have a taxable profit from your rental when in fact you do.
Tax is assessed based on your net profit – that is, what’s left as income after expenses have been deducted. Rental income is the same way as any other business: you pay tax on the difference between the gross rents you collect, and the expenses you deduct on the rental property*. The only way to have $0 tax on your rental is to have $0 net profit.
Many part-time landlords mistakenly think that if the rent is just enough to pay the mortgage, their profit, and therefore their tax, is zero. Unfortunately, that’s not always the case.
Let’s say you own a condo that you’re renting out, and you collect $1,500/mo in rent. Out of that, you pay condo fees and property tax totalling $500, plus a mortgage payment of $1,000. At the end of the month, you have $0 new dollars in your bank account. You might think that your profit, and therefore your tax, is $0.
HOWEVER: a mortgage payment includes both an interest portion, and a repayment toward the principal of the loan. The amount of a property that’s ‘paid off’ is called equity. When you apply a payment to the principal of the loan, the portion of the principal you’ve paid off becomes equity. Put a dollar toward the principal of your mortgage, and you’ve increased your equity by $1.
Essentially, then, the portion of a mortgage payment that gets applied to the principal isn’t ‘spent’ so much as converted: from cash to equity.
On way to visualize this is to think of the property as a house, made up of many bricks. When you took out your mortgage, the bricks belonged to the bank; as you pay down the principal of the mortgage, the bricks become yours, a few at a time, until the mortgage is paid off and the whole house is yours. You had cash, and now you have equity of equal value.
Why does this matter?
Because the portion of the rent that ultimately pays off some of the principal of your mortgage is considered profit to you, and is therefore taxable. Even if you never saw any increase in your bank account (cash), it’s still profit (equity, or ‘bricks’).
So in our example, say that of your $1,000 mortgage payment (all covered by the rent), $300 is interest and $700 is principal. You get to write off $300 as a borrowing expense, but the other $700 is still considered profit even though you had to give it directly to your mortgage lender.
So that’s why even if you charge rent equivalent to the amount of cash that is flowing out of your account in order to pay the overhead, you still make a profit on paper and still have to pay tax (usually around 31% of the profit, or $217 in our example).
*or the part of your property you’re renting out, if you’re renting out part of your own home.