Cash deal, or borrow? (tax differences?)

General Real Estate Investing
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Cash deal, or borrow? (tax differences?)

CL Ziegler
Investor · Albany, GA · Member since 2014 · 70 posts · 8 votes

I've asked this before, and came away MORE confused. So let me try again.

Another poster on here in an older thread said: "In a few years when my units are paid off, I can keep the full rents as profit." (paraphrasing)

Is this true?

I thought carrying a note on the unit knocks down your tax burden on the rental revenue? (income tax)

I don't hear many people here talking about income taxes. (maybe I'm in the wrong threads). But, seems to me that no matter what the thread, if taxes play such a huge role then they should be mentioned regularly, regardless. To me taxes shouldn't be a gray area; either you can or can't (by law) deduct this or that expense.

So once more, as a pointed question:

If you are able to fully pay off a rental unit, -VS- keeping a note with interest on it, which one is more appealing?

As a sub-question, is it true that ALL interest on a bank note is considered business expense, VS the percentages deducted for interest on a home mortgage?

Thanks!

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  • Jason Rutledge
    Investor · Sugar Land, TX · Member since 2013 · 26 posts · 2 votes
    12y
    If your happy with the ROI of the rental with you paying off than do so. Side note: make sure your diversified ; ). I would personally like to pay tax on income instead of getting a deduction- there is also a point that if you make too much the government says you lose the deduction but it could be carried and used another year your income Is lower...... I believe. Not a tax pro! So then what's your end game.... A few rentals to help fund retirement or a Realestate empire??? Make a five year plan and good luck.
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  • Kyle Hipp
    Investor · Appleton, WI · Member since 2012 · 1k+ posts · 464 votes
    12y

    CL, just for easy numbers. If I have a property, that I self manage, that has monthly rents of $1,000 and I have monthly expenses of $400 between my capital reserves, vacancy, repair expenses, property taxes and insurance. Then I have $600 left to be left for profit. If I have a mortgage (principle and interest) of $400 then I am currently profiting $200/m. I have an interest deduction on my taxes of $200 (this means that I am saying that of my $400 mortgage payment the interest is $200/m and the principle reduction is also $200/m). The $200 I pay in interest each month is a deduction which at the 25% tax bracket will save me $50/m in income taxes. However my income is $400/m with $200 being cash in my pocket cashflow and the other $200/m being used for principle reduction on the mortgage. So in thispath (I am not bringing in depreciation just for simplicity sake), I have a taxable profit of $400/m and in the 25% tax bracket my liability is $100/m and I have $300/m in my pocket. If I pay off the mortgage I have $600/m in profit and will pay $150 in income taxes however I will have $450 in my pocket.

    Between those two choices with income taxes being the deciding factor then it is better to pay off the mortgage to have a higher income and only slightly higher taxes. Broken down the $200 you spend in monthly interest only costs you $150 because you have a tax benefit. If you do not have to pay interest you pay that $50 in income taxes but you have the other $150 in your pocket which is a larger benefit.

    The choice as to whether pay off a mortgage or continue to use leverage depends entirely on the investors risk tolerance and their goals. I am 28 and want to retire from my day job by age 40 and work in my rental real estate business full time. I have my current properties on 15 year notes so by age 40 they will be gone or have so little owed that I could pay them off and have my day job income replaced. I just want options. I currentlt want more properties so instead of putting my resources into paying down debt, I focus on growing my business. Other folks might be in different positions thus would much rather have more income and less debt.

    As to your sub question. I am not sure what you mean by a percentage for a home deduction. The interest I pay on my personal residence is all eligible for a tax deduction on schedule A. Any expense that I incur on my business is also deductible on my schedule e for my rental property. Some thing that might confuse you is that only interest is tax deductible. So if your mortgage (just principle and interest is $400/m and of that payment $200 is an interest payment then in both cases that is the only thing that is deductible whether on schedule a or e.

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  • CL Ziegler
    OP
    Investor · Albany, GA · Member since 2014 · 70 posts · 8 votes
    12y

    Thanks Jason and Kyle!

    Kyle, the sub question only came up because in another thread I saw posters saying one can only deduct 3.5% of the sum of mortgage interest paid, which confused me since I was also told that all loan interest (schedule e) went against rent revenue, not just a portion of the interest.

    I think the poster who said that was referring (maybe?) to home interest loans, rather than the schedule e business loan interest. That's just a guess though.

    Kyle thanks for the great reply. I love your illustration. And yes, I see that strategy has everything to do with it. I am in the "build/add/grow" stage too so I see leveraging/borrowing as a necessary thing at this stage.

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