Often, landlords have confusion around how to calculate the taxable income from their rental properties. The three variables that drive this confusion are loan principal payments, depreciation, and amortization.
Loan principal payments are not tax deductible. Think of it as moving money from one pocket to another. You are reclassifying cash flow as equity.
For example, if gross rental income is $10,000, expenses are $2,000 and the total mortgage payment is $5,000, you would have cash flow of $3,000.
But if your principal portion of your total $5,000 in mortgage payments was $1,500, then you cannot deduct the $1,500 in figuring your net rental income. So in this example, our net income would be $4,500 even though our cash flow is only $3,000.
But net income is not net taxable income. Thanks to depreciation and amortization we get to further reduce our net income to determine the amount of income we pay tax on.
Continuing the above example, let’s assume our depreciation and amortization is a combined $3,000 for the year. We would reduce our $4,500 in net income by that amount to find that our net taxable income for this rental property is $1,500.
So we have $4,500 in net income, $3,000 in cash flow, but our net taxable income is only $1,500!