Tax Advice for Rental Property Owners

My vacation rental business owns 23 properties on which we make over $200,000 in principal payments annually. Since we make $195,000 in annual profit, every year we end up in the hole financially. We take depreciation on the properties, but it doesn't offset our taxes by much. Is there a way to deduct the principal payments we're making on our properties? —D.P., Cartersville, Ga.

No. "You cannot deduct principal payments on loans," says Bill Fleming, a managing director at PricewaterhouseCoopers. "This is a typical issue with any leveraged investment—especially real estate, since that is nearly always leveraged."

When business owners make principal payments to pay down debt, such as you are making on your real estate mortgages, your cash flow is impacted negatively. However, making those payments means you are building equity in your assets, so they are not expenses that reduce your profit and therefore cannot be used as tax deductions.

Consider Refinancing

A business such as yours is typically considered a long-term wealth generator, assuming you can keep the properties in good condition long enough to sell them for substantially more than you paid for them. (In today's real estate market, of course, this strategy may be much tougher to achieve than it was a few years ago.)

Since interest rates are extremely low currently, you might consider refinancing any of the properties that have gained significant equity since you purchased them, suggests Michael Hanley, a CPA based in Smithtown, N.Y. "At today's lower rates, you should be able to reduce monthly payments, or pay down mortgages on other properties that don't have enough equity to refinance but are encumbered with high-interest-rate mortgages," he says.

You could also check with your state's licensing board to see if you meet the tests to be considered a qualified real estate professional. That status might allow you to deduct more of your losses in a given year, Hanley says.

Look Into Shorter Depreciation Schedules

Another idea is to have a cost-segregation analysis done on your properties. This is a strategic tax tool used for commercial and rental property firms that can reduce your tax liability by shortening depreciation schedules on some of the assets installed in or associated with your properties, Hanley says. "Typically, on commercial and rental properties, mortgages are amortized over 15 or 20 years. However, the property is depreciated over a much longer time frame—usually 27½ or 39 years. This means that your principal payments may end up being double the amount of your depreciation deduction."

A cost-segregation analysis would identify components of your properties that would qualify for depreciation over more rapid time frames, such as 3, 5, 7, or 15 years. Doing that would enhance your cash flow by reducing your tax liability now and more effectively match your depreciation expenses to your mortgage payments, Hanley says.

Specialty accounting firms do cost-segregation analyses but the fees can be substantial, so explore the cost and the potential for tax savings with your own accountant first. In order to withstand a challenge from the Internal Revenue Service, you'll need to obtain a certified cost-segregation analysis report if you decide to have one done, Hanley says.

Source:Business Week

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