Landlords can deduct mortgage interest from rental income taxes
What you need to know
- Landlords who rent out a property can deduct mortgage interest from rental income taxes as a business expense.
Your next steps
- Let’s look at Karl’s story, based on an example from VLH tax specialists, to illustrate how this works.
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How to deduct mortgage interest from rental income taxes
Karl bought a semi-detached duplex in the country three years ago. He and his wife live on the right, and his tenant on the left. To purchase the home, Karl took out a loan from his bank for a term of 13 years with monthly payments on the mortgage.
Every year, Karl can deduct mortgage interest from rental income taxes. Since interest on the loan for the mortgage classifies as income-related expenses, he as a landlord can deduct the interest from his taxes.
What is important is that the tax office can clearly see exactly how much interest Karl pays for the rented property. Only then can he deduct mortgage interest from rental income taxes. Then, only what is left is taxable.
Note: If Karl and his wife were to divorce, that would not change the loan agreement. The one who signed the loan agreement is always the one liable for payment, and in this case only Karl signed the agreement. The bank is not interested in whether one of the spouses moves out or if there is a divorce. Karl’s wife cannot be held responsible for her husband’s debts.
How to structure your purchase
Landlords can maximize tax savings on rental income by carefully planning the property purchase.
Include rental details in the purchase contract
To return to Karl’s situation, he can deduct mortgage interest from rental income taxes because he did everything right. He wrote down in the purchase contract exactly which half costs how much, where he and his wife will live, and which part he rents.
Set up separate bank accounts
Most importantly, Karl set up two separate accounts at his bank: one account for his half, and another account for the loan to finance the rented half. This allows him to easily prove to the tax office that he only wants to deduct interest for the rented half.
Altogether, Karl’s duplex cost €200,000. He was able to bring €100,000 in equity for his half of the house. He borrowed the remaining €100,000 for the second part of the house. Every year, he pays 5% interest on the loan (€5,000). He can deduct this money completely from his taxes.
If a landlord receives the bank loan on one account and finances the entire duplex from this one account, the landlord cannot deduct mortgage interest from rental income taxes.
Why is this? Because the tax office could not clearly see how much interest the landlord pays. In Karl’s case, the tax office needs to see the mortgage interest that Karl pays for the half of the duplex that he rents out. There are only tax breaks for the rented home, not for the space that Karl occupies himself.
An unclear situation can complicate taxes
Unless the landlord allocates the loan interest precisely, the tax office will calculate the interest independently. The tax office’s calculations are usually less favorable. Generally, the tax office will simply evenly split the total interest for the loan between the self-occupied and rented living spaces.
In Karl’s case, this looks like:
150 sq. meters (the rented half of the house): 300 sq. meters (the duplex’s total living space) x 5,000 € (total loan interest/year) = €2,500.
So, if you plan to purchase a home or apartment for rent, plan to seek advice before you take out the loan. Even the smallest mistake can cause the tax office to improperly assign the loan interest. Careful planning ensures that you can deduct mortgage interest from rental income taxes.
Landlords can deduct mortgage interest even after selling the property
When a landlord sells his property, the proceeds usually go to repaying the remaining loan. However, what if the funds are insufficient to settle any remaining debt? Then, landlord must continue to pay off the loan.
In this case, interest continues to apply. So, the landlord can continue to deduct the interest from his taxes. The interest then qualifies as so-called additional income costs for income from leasing and letting in Annex V. This applies to all real estate sold after 1998.
However, the landlord must fill the two following conditions:
- 1) The landlord cannot redeem liability (i.e., pay off the loan) with the proceeds of the sale.
- 2) The landlord must still intend to generate further income from letting and leasing, even before the sale of the property.
Special conditions for sales before 1999 : no additional expenses
If you sold your property before January 1, 1999, mortgage interest no longer qualifies as subsequent expenses. In this situation, a landlord cannot deduct interest payments on a mortgage from taxable rental income The Federal Ministry of Finance in Germany justifies this decision by pointing out that lending rates must remain tied to the actual rental as an economic connection.
Landlords may deduct interest on debt rescheduling loans
Landlords may deduct interest on debt rescheduling loansIn many cases, a landlord pays a very high interest rate on a current loan and could benefit from a lower interest rate on a new loan, If so, the landlord can repay his loan or refinance.
If the landlord has already sold the property, the landlord can deduct the cost of the rescheduled loan interest as a subsequent cost of income from the tax. However, the value of the rescheduling loan must not exceed the residual loan to be replaced. The debt rescheduling moves under a usual financing BFH clarified in a judgment on April 8, 2014 (file reference IX R 45/13).
Note: if the landlord completely repays the loan ahead of schedule, the landlord may have to pay a what is called a prepayment penalty to the lender.
For more information, please see our blog article on taxation and leasing for a buy-to-let mortgage.
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