Tax Downsides to Paying Off a Mortgage

Jericho, NY · Member since 2016 · 29 posts · 5 votes

Hello everyone! My name is Jesse and I am a new investor. I am about to close on my first property on march 22nd (tuesday!). It is a $250000 2 bedroom condo in the NY metro area. I will be renting this apartment out after I purchase it. However, I am trying to weigh the pros and cons of aggressively paying off my mortgage.

I graduated school with 100,000 dollars worth of student loan debt in 2013. I started to pay the minimum at first. I asked around about the benefits and found out that I would get the interest back on my tax returns. So I sat around and thought about it. BAsically, I pay the interest to the government for my loan, and then they give it back to me. Sounded like a very silly game to me. So I decided to aggressively pay back my student loans. I finished paying it in 10 months.

Now I know when you buy a property, you get other tax benefits besides just the interest on your tax returns. My question is, is it a better approach to aggressively pay it off like i did with my student loans, or are there other tax benefits to slowly paying off the mortgage?

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Kevin Yoo

San Diego, CA · Member since 2008 · 301 posts · 108 votes

10y

Hmmmm. It seems as though either there is a failure to understand debt and leverage by the BP Community or some members of the Community simply are so debt aversive that they do not care about the different types of debt and the power of leverage. I am OK with the latter but I would be disturbed if the commenters to the original question simply failed to understand the former. This would mean that many in BP fail to understand the simple concepts of debt in real estate investing.

@Account Closed. THE ANSWER TO YOUR QUESTIONS IF THERE ARE OTHER TAX BENEFITS TO SLOWLY PAYING OFF THE MORTGAGE IS NO. However, I hope you read the rest of this and find it helpful. There is a big difference between your student loan debt and the debt on your investment property as mortgage. Kiyosaki called them bad debt and good debt. The student loan debt does not generate for you any wealth (except for tax deductions on interest paid out). This is bad debt akin to owning a yacht, big screen television, or carrying a balance on credit card.

The mortgage on your rental is good debt because it generates wealth for you. I hope I am insulting your intelligence when I say this because the reasons how it does this are really obvious.

Interest deductions: I know many have discounted this and yes, it is only a fraction of what you pay, but if you have 500 rental properties and are in the highest tax bracket possible, this will be very very valuable. If you plan to only own a few rentals, then I understand why you would want to own them free and clear and that is totally OK.
Depreciation: I know this has to be recaptured at time of sale and you have to pay taxes on that, but again if you own many many rentals, this is a tremendous deduction. Again, if you want to own a few rentals forever without ever selling, then paying off your mortgage quickly is a fine strategy.
Higher Return (IRR): If you have $100,000 into your rental because you paid off the mortgage as opposed to only $30,000 because you put a mortgage on the property, then the net income you get as a return of the cash you invested is higher with the second scenario even after taking into account the mortgage payments. If you have all paid all cash for a property, the returns are very typically in single digits. If you leverage with a mortgage, then the returns are typically in double digits many times in 20 or even 30%ile.
Leverage: If you spend all $100,000 to own a property, you have all that money tied down into that one property. If you have only $30,000 sunk into that one property, you can go and own two more properties like this one with 30% down. Your returns on your money is again much much higher.

There is, no doubt, tremendous benefits to owning properties free and clear. I wish I had all my properties that way. There is no doubt there is great danger in having mortgages. I have learned that lesson the hard way. But I plan to own thousands of income generating properties. I cannot get there without using debt, at least not in my lifetime. Therefore, I spend a lot of time understanding debt and mastering the use of it, so that I accomplish my real estate investment goals.

The philosophical way to answer your question is for you to answer how big of a portfolio do you want. If you want to stop at a few properties, paying them off is safe and just fine. But if you want to own a large portfolio, be as aggressive at learning how to create good debt and use it as you were so aggressive in paying down your student loan. Just acquiring debt without understanding it, is in my opinion, as stupid as paying down your mortgage as fast as you can without really understanding how that is affecting all of your other finances. Lastly, don't ever worry about how much interest you are paying to the bank because it is definitely a lot and thinking about it will only drive you crazy. Just realize that this is part of doing business and instead realize that you are not paying the interest. Your tenants are.

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Brian Smith
Rental Property Investor · Shreveport, LA · Member since 2015 · 36 posts · 18 votes
10y
The interest incurring on a traditional mortgage is MUCH greater than any tax benefits you may save on the interest. For example if I owe 100,000 on a house and monthly payments of say 500, 100 goes to principle and 400 to interest. In that calendar year I paid 1200 towards the loan and 4800 towards the interest. Yes, I get a tax break on the 4800 in interest i paid, but if I would have paid an extra 100 a month (1200 over that year) I would have saved 4800. why pay 4800 in interest for a $300 tax break? Anyone who says don't pay the extra doesn't understand compound interest or understands interest and wants to loan you more. For me the ONLY time to not aggressively pay a mortgage down is when I need the capital for the next mortgage. Just my 2 cents. Get with a good cpa, there are many tax benefits to owning your rental and congratulations!
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Albert Okagbue
Certified Public Accountant · Houston, TX · Member since 2015 · 72 posts · 24 votes
10y
Jesse - It sounds to me like you already have an aversion to debt. I would turn around and ask you a question: What prompted you to think about this?
It sounds like you earn well. You already paid off your student loans. Why are you even considering not doing the same with investment properties?
I would appeciate more info from you so that I can give a thoughtful response.
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Chris Soignier
Real Estate Broker · North Richland Hills, TX · Member since 2013 · 1k+ posts · 607 votes
10y
You don't get the interest back in taxes - just a deduction on the amount of interest paid, and that's assuming you have enough deductions to justify itemizing. If you're in the 25% marginal tax bracket, you'll save $250 in taxes for every $1000 of interest expense.
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Brandon Hall
CPA · Raleigh, NC · Member since 2013 · 1k+ posts · 2k+ votes
10y
As the above have correctly stated, the interest is a write off which reduces your taxable income generated from passive activities which subsequently reduces your overall taxable income and corresponding tax liability.
While tax considerations are always important, I encourage you to understand the real purpose of debt.
Debt, in most cases, is not undertaken for tax benefits. It's a tool used to get into assets one cannot buy outright. More importantly, using leverage allows you to realize much higher returns vs. not using leverage.
So while it's a great to ask about the tax pros and cons, ultimately the difference will be nominal compared to the decrease of your IRR should you aggressively pay down the debt.
6 Reply
Mike Landry
Investor · Montgomery, TX · Member since 2014 · 386 posts · 151 votes
10y
I like to think of diversification. When you pay your mortgage down, you are essentially investing at an earning of what your mortgage rate is...4.5% or so. This is a very safe conservative investment. What else is in your investment portfolio? Can you earn a higher rate somewhere else?
Are you younger and trying to grow your portfolio? Then be more aggressive and put that money into the next property.
Are you nearing retirement? Go more conservative and pay off your mortgage.
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Mike Landry
Investor · Montgomery, TX · Member since 2014 · 386 posts · 151 votes
10y
I guess I missed the tax part of the question, sorry. I think the tax benefit is a minimal consideration when considering your return on cash, return on equity, and power of leverage.
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Brian Mathews
Contractor · Round Rock, TX · Member since 2013 · 767 posts · 389 votes
10y
Pay it off. Why give the bank a dollar to save giving the gov't a quarter. If you paid off $100K in less than a year. You'll have this place paid off in 2 years.
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Kevin Yoo
San Diego, CA · Member since 2008 · 301 posts · 108 votes
10y
Hmmmm. It seems as though either there is a failure to understand debt and leverage by the BP Community or some members of the Community simply are so debt aversive that they do not care about the different types of debt and the power of leverage. I am OK with the latter but I would be disturbed if the commenters to the original question simply failed to understand the former. This would mean that many in BP fail to understand the simple concepts of debt in real estate investing.
@Account Closed. THE ANSWER TO YOUR QUESTIONS IF THERE ARE OTHER TAX BENEFITS TO SLOWLY PAYING OFF THE MORTGAGE IS NO. However, I hope you read the rest of this and find it helpful. There is a big difference between your student loan debt and the debt on your investment property as mortgage. Kiyosaki called them bad debt and good debt. The student loan debt does not generate for you any wealth (except for tax deductions on interest paid out). This is bad debt akin to owning a yacht, big screen television, or carrying a balance on credit card.
The mortgage on your rental is good debt because it generates wealth for you. I hope I am insulting your intelligence when I say this because the reasons how it does this are really obvious.
1. Interest deductions: I know many have discounted this and yes, it is only a fraction of what you pay, but if you have 500 rental properties and are in the highest tax bracket possible, this will be very very valuable. If you plan to only own a few rentals, then I understand why you would want to own them free and clear and that is totally OK.
2. Depreciation: I know this has to be recaptured at time of sale and you have to pay taxes on that, but again if you own many many rentals, this is a tremendous deduction. Again, if you want to own a few rentals forever without ever selling, then paying off your mortgage quickly is a fine strategy.
3. Higher Return (IRR): If you have $100,000 into your rental because you paid off the mortgage as opposed to only $30,000 because you put a mortgage on the property, then the net income you get as a return of the cash you invested is higher with the second scenario even after taking into account the mortgage payments. If you have all paid all cash for a property, the returns are very typically in single digits. If you leverage with a mortgage, then the returns are typically in double digits many times in 20 or even 30%ile.
4. Leverage: If you spend all $100,000 to own a property, you have all that money tied down into that one property. If you have only $30,000 sunk into that one property, you can go and own two more properties like this one with 30% down. Your returns on your money is again much much higher.
There is, no doubt, tremendous benefits to owning properties free and clear. I wish I had all my properties that way. There is no doubt there is great danger in having mortgages. I have learned that lesson the hard way. But I plan to own thousands of income generating properties. I cannot get there without using debt, at least not in my lifetime. Therefore, I spend a lot of time understanding debt and mastering the use of it, so that I accomplish my real estate investment goals.
The philosophical way to answer your question is for you to answer how big of a portfolio do you want. If you want to stop at a few properties, paying them off is safe and just fine. But if you want to own a large portfolio, be as aggressive at learning how to create good debt and use it as you were so aggressive in paying down your student loan. Just acquiring debt without understanding it, is in my opinion, as stupid as paying down your mortgage as fast as you can without really understanding how that is affecting all of your other finances. Lastly, don't ever worry about how much interest you are paying to the bank because it is definitely a lot and thinking about it will only drive you crazy. Just realize that this is part of doing business and instead realize that you are not paying the interest. Your tenants are.
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Account Closed
OP
Jericho, NY · Member since 2016 · 29 posts · 5 votes
10y
Wow. Thank you for all the responses! I think the general answer here is to pay it off aggressively unless I plan to get more properties and debt in the future correct? in that case, I should save up collateral to pool into growing my portfolio. I am sort of dipping my toes in the pool to test the waters with this one. How aggressively i want to pursue my real estate portfolio in the future depends on how much i enjoy doing this. I was under the impression that you were able to get a much higher return on your taxes for the interest payments so this information was definitely useful. how about other deductibles such as depreciation or itemized deductibles? are they affected by early mortgage payments as well or will i still get the benefits if i pay aggressively?
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OP
Jericho, NY · Member since 2016 · 29 posts · 5 votes
10y
Originally posted by @Albert Okagbue:

Jesse - It sounds to me like you already have an aversion to debt. I would turn around and ask you a question: What prompted you to think about this?
It sounds like you earn well. You already paid off your student loans. Why are you even considering not doing the same with investment properties?
I would appeciate more info from you so that I can give a thoughtful response.

I suppose it's from a lot of misinformed people that are clueless about debt. For example, I have a friend that insists that it makes sense to only pay the minimum on her credit card because she will get the interest back on her taxes(not sure if thats true or not). Me, i prefer paying the full quantity every single month and starting fresh from 0 debt.
I know that real estate provides benefits for tax situations. but i'm just not sure how much. I make about 135,000 per year after taxes so i have the option to pay it off in 2 years or less if i really tried. But i want to make sure i have all the correct information before i make a decision
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Steven Hamilton IIPro Member
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
10y
You can happily hand me dollar after dollar and I'll give you back the ~40 cents that you'll save.

Never spend money just for a tax deduction. Think of the best use of your money. Can it be invested at a higher rate than you're paying?
[email protected]224-381-2660
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OP
Jericho, NY · Member since 2016 · 29 posts · 5 votes
10y
Originally posted by @Kevin Yoo:
Higher Return (IRR): If you have $100,000 into your rental because you paid off the mortgage as opposed to only $30,000 because you put a mortgage on the property, then the net income you get as a return of the cash you invested is higher with the second scenario even after taking into account the mortgage payments. If you have all paid all cash for a property, the returns are very typically in single digits. If you leverage with a mortgage, then the returns are typically in double digits many times in 20 or even 30%ile.
Hmm, the other points are definitely plain and simple. but this one is a bit confusing. does it mean that because you put in more money, the returns percentage wise are technically less? wouldn't that even out after you finish paying the mortgage in 30 years?
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Wade G.
Houston, TX · Member since 2010 · 150 posts · 159 votes
10y
In addition to what has already been mentioned there is one other reason not to pay off a rental and that is asset protection. If you are sued and your 100k rental is paid for it will look very attractive to the attorney. If your rental is leveraged at 70% LTV it will not look as attractive and you would only stand to lose 30k versus 100k. In my opinion there is nothing wrong with debt on real estate as long as you keep adequate reserves for the hard times. I'm in Texas and if I wanted to pay off a piece of real estate it would be my primary residence since it is my homestead.
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Kevin Yoo
San Diego, CA · Member since 2008 · 301 posts · 108 votes
10y
@Account Closed
I think the general answer here is to pay it off aggressively unless I plan to get more properties and debt in the future correct?
Sort of yes. It depends on how many properties you want to own. If you only want a few, you don't need debt to make you happy and enjoy good safe returns. If you plan to own many, then debt becomes very helpful.
how about other deductibles such as depreciation or itemized deductibles? are they affected by early mortgage payments as well or will i still get the benefits if i pay aggressively?
No. Depreciation and itemized deductions are not affected by how much debt you have on the property.
For example, I have a friend that insists that it makes sense to only pay the minimum on her credit card because she will get the interest back on her taxes(not sure if thats true or not).
Personal credit card interest payments are not deductible.
does it mean that because you put in more money, the returns percentage wise are technically less?
Yes, it does mean that the returns are less. Look at this link for a property we are considering purchasing in Chicago, Illinois.
https://www.dropbox.com/s/w17g38sss8xoh1t/7718%20L...
On this property the cash on cash return goes from 9.96% with all cash purchase to 20.35% with 25% down payment. Significant difference.
wouldn't that even out after you finish paying the mortgage in 30 years?
Not really. Think of all the lost opportunity for generation of other income because you had all of your money tied into one property. Again, if you do not want to or more importantly have the ability to look for and take advantages of other opportunities, then paying down the mortgage is fine and good idea. But if you have the time, skill set, and desire to pursue more, you must use GOOD debt.
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Thomas S.
Member since 2016 · 13k+ posts · 12k+ votes
10y
The most important factor for new investors to consider is the difference between good and bad debt. Debt in a investment income property is good debt in that you are earning a income from it while the income is paying that debt and supposedly providing you a return on the money you have invested. The upside is that your tenants pay that debt not you.
What you must keep in mind is that the property is required to earn a income to pay the expenses on the property as well as paying the mortgage but in addition must pay the owner a return on any equity tied up in the property. The greater the equity tied into the property the greater the income required to justify the investment. Money must earn it's keep.
Money sitting idle in a property can never earn a greater return than the existing mortgage rate on the property. If your mortgage is at 5% any equity in that property can only earn you a 5% return less the tax deductible on 5% interest so say maybe 3.5%. That is the maximum return you can earning on equity in that property.
Personally I can do better in a mundane mutual fund than allowing equity to sit idle in a property.
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Albert Okagbue
Certified Public Accountant · Houston, TX · Member since 2015 · 72 posts · 24 votes
10y
Jesse, thanks thanks for answering.
I want to start by correcting the person who said student loan debt is bad debt. This is toxic thinking in my view because an education is no less an income producing asset than a house. You cant sell it which may be bad, but nobody can ever take it away or damage it either. Good debt increases your ability to accumulate cash and does so at a rate higher than the cost of borrowing. Your guy's student loans do just that...Also most student loans don't require credit which is a bonus.
Next, the other folks are right about how taxes work. I think you have to decide what your real estate goals are and model the resources needed. If you can do it without debt that can be good. Most of us don't make $135K so the debt allows us to do more. Can you do more? Do you want to do more? Do you like your job?
Until you have a answers....I would keep paying them off as a default option just because it benefits you many ways....outside of tax.
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Chris Soignier
Real Estate Broker · North Richland Hills, TX · Member since 2013 · 1k+ posts · 607 votes
10y
I don't want any of my real estate paid off. Leverage is what juices cash-on-cash returns in real estate....without leverage, the returns often aren't that appealing. Besides, I can come up w/ much higher yielding investment alternatives w/ the after-tax cost of mortgage debt.
I like to think of debt as shorting the dollar. Borrow now @ low interest rates, pay back in the future w/ $$$ that will be worth much less. Do you believe that the USD will continue to devalue? If so, that's another good reason for levering your real estate investments.
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Patrick LiskaPro Member
Investor · Verona, NJ · Member since 2014 · 1k+ posts · 832 votes
10y
think of it this way as well, yes you only get a quarter of the money paid to the interest at tax time but on the other hand, if you pay off the mortgage you will be taxed for that income you made that you are not paying in interest, remember if you have a mortgage on the property, you are buying that property with other peoples money ( bank or private lender ) why not get the tax break on the interest you pay back to them for the loan. now your interest rate may have gone from 4.25 to 4 % after tax deduction. as stated in other posts, its a part of doing business and all the costs of doing business should be accounted for when you run the numbers on your properties, the tenants should be paying for it, anything above an beyond is profit. you shouldn't get worked up about how much you save in interest by paying it off early, it doesn't matter, if you make a steady income from money borrowed from other people.
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Thomas S.
Member since 2016 · 13k+ posts · 12k+ votes
10y
@Albert Okagbue:

.
I want to start by correcting the person who said student loan debt is bad debt.
To clarify: getting a student loan is perhaps a necessary debt, once that debt has accomplished it's purpose a student loan becomes a bad debt.
Once you graduate the purpose of the loan becomes null and void and is simply a debt that is no longer anything but a burden. The debt only served a positive purpose while being used to earn a education. Once you graduate you become the vehicle of value not the debt.
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Albert Okagbue
Certified Public Accountant · Houston, TX · Member since 2015 · 72 posts · 24 votes
10y
Originally posted by @Thomas S.:

@Albert Okagbue:
.
I want to start by correcting the person who said student loan debt is bad debt.
To clarify: getting a student loan is perhaps a necessary debt, once that debt has accomplished it's purpose a student loan becomes a bad debt.
Once you graduate the purpose of the loan becomes null and void and is simply a debt that is no longer anything but a burden. The debt only served a positive purpose while being used to earn a education. Once you graduate you become the vehicle of value not the debt.
I am trying to follow your logic here.
Let's say I own a real estate property that earns me $10,000 a year. Then Home Depot says if I spend another $200K on it, they will pay me 40K per year on top of the $10K I already earn. Following your logic the $200K is only valuable during the construction period BEFORE I start collecting increased rents.... I don't see how that works. I would think that the $200K adds to my asset and $200K loan adds to my debts. As long as I earn more than the cost of debt, i am ahead and can even pay it off faster. I wouldnt see that as a burden.
Please enlighten me.
What exactly makes Student Loans different from the construction or rehab scenario I gave above?
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Thomas S.
Member since 2016 · 13k+ posts · 12k+ votes
10y
Your post shows you as a certified public accountant. I would suggest, for the sake of your business, you may want to erase your previous post.
4 Reply
Matt H.
Real Estate Broker · CA · Member since 2016 · 243 posts · 226 votes
10y
@Mike Landry and @Steven Hamilton II have it correct. Yes there are tax advantages to debt and one must be cognizant of those. But the big picture question is are you at the beginning of your career and can you make more than your interest rate? I know I always can so until I get tired of this and want to retire I'm always going to by more not pay anything down. And even then maybe I'll just pay someone else to buy more for me. Leverage is the most powerful tool in real estate. Become a master of it and you should have no issue winning.
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Rob Hayes
Investor · Union, NJ · Member since 2015 · 7 posts · 1 vote
10y
I have a question regarding all these answers. Why has no one mentioned a Home Equity line of credit or loan if this person decided to pay down the debt aggressively. I have a similar situation. I have about 100k liquid and 65k owed on a rental property valued at approx 270k. I am considering paying it off which will increase monthly cash flow significantly which I will save for future investing or use it to pay down my primary residence, however if I need a large some of cash I will use a home equity line of credit of my rental property. What is the problem with this strategy? FYI- there is 9 years left on this 65k at 4.75%
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Dave Toelkes
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
10y
@Account Closed
There are three advantages to owning rental property: Cash flow, Appreciation, and Tax benefits.
As a general rule, rental property owners do not buy a property for tax benefits nor for appreciation. Appreciation may or may not happen, and, when it does happen, it happens slowly. Tax benefits sometimes come at the expense of cash flow, but tax benefits are more like the icing on the cake and not the sole reason to buy rental property. The best tax benefit for a rental property owner is the depreciation expense deduction. You get the full depreciation expense deduction no matter whether you have a loan in place or own the property free and clear.
What you need to do is tell us why you want to become a landlord. What future goal does rental property ownership achieve? If you want to retire with an income that meets your lifestyle needs for the rest of your life, then how much CASHFLOW will that take and how long do you have before retirement. Next, determine how many properties you need to own to satisfy that cashflow requirement. If your retirement lifestyle will need $5000 per month, then you can probably make that happen with 50 financed properties, or with five to eight free and clear properties.
Once you know how many properties you will need in your portfolio, then you may want to be more aggressive about acquisition than you are about debt reduction. Once you have purchased the number of properties you need, then be aggressive about debt reduction. Until you define your goal, you will never have a clear plan to get there Until then, discussions like this one are not going to give you any meaningful direction.
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Account Closed
Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes
10y
Jesse
Which would you rather have?
1. $500,000 in your pocket TODAY,
or
2. $2,387 a month for the next 360 months (That's ending in 2046!)
That's the easy answer!
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