Investor · Wichita Falls, TX · Member since 2010 · 3k+ posts · 603 votes
Hi all,
At my family party yesterday I had a chat with my uncle who owns an apartment building and is very successful in other businesses. He told me that any principal paydown on an investment property is considered taxable income because the amount payed down has gone from a liability to an asset. This is the first I've heard of this and it just doesn't sound right. I wanted to run it by some of you tax guys!
I know he owns the apartment building in an LLC and has other entities for his other businesses if that can factor in on this tax situation.
The actual paydown amount isn't taxable. That is, if you start the year with $100,000 in debt and you end the year with $95,000 in debt, you do not have $5000 in taxable income.
Now, what he might be referring to is the principle paydown isn't a deduction. If your total payments for that year were, say, $20,000, and $5000 of that went to paying down the principle and $15,000 went to interest, only the $15,000 is deductible. Not the full $20,000 you actually mailed to the mortgage company. The interest is paid with pre-tax dollars and the principle is paid with after tax dollars.
The actual paydown amount isn't taxable. That is, if you start the year with $100,000 in debt and you end the year with $95,000 in debt, you do not have $5000 in taxable income.
Now, what he might be referring to is the principle paydown isn't a deduction. If your total payments for that year were, say, $20,000, and $5000 of that went to paying down the principle and $15,000 went to interest, only the $15,000 is deductible. Not the full $20,000 you actually mailed to the mortgage company. The interest is paid with pre-tax dollars and the principle is paid with after tax dollars.
Thanks for confirming what I was thinking. After all the REI books I've read that have delved into the tax benefits of investment properties and reading tax questions on the forums for a long time now, I was pretty certain.
I tried to get him to clarify by asking if what he meant was that only the interest was deductible and that's when he explained the whole asset to liability spiel.
He seemed pretty confident about it and I didn't want to bump heads with him due to me being half in a food coma from all the great food.
Assets aren't taxed. Income is. He is correct that as you pay down the principle, your assets increase and your liabilities decrease. But that doesn't increase your income tax bill. Perhaps he's thinking of some other sort of tax.
Also note that debt has no effect on capital gains tax. Capital gains tax is the same whether the property is free and clear or mortgaged to the hilt. That came as a surprise to some folks who refi'ed and HELOC'ed all the money out of their house as values rose, then had to do a sale that generated no actual cash after they paid the selling costs. "How can I have tax bill, I received nothing on the sale?" Well, because you took your gains when you did those cash out refis.
Second point duly noted! I Just took out a HELOC on my primary and that is definitely important to remember. I've made some improvements and also depreciate 33% (portion of home from renting out spare rooms) that are going to affect the basis/how much I get taxed down the line also. I'll have to do the math when I sell to see how the numbers actually pan out and plan accordingly.
You got good answers above from guys that know. I didn't think it sounded right either! Though not principal reduction, you do have to recapture depreciation when you sell and the tax guys here can explain the innuendos of that if you ask. BP has a wealth of very smart people that are always willing to help!
The answers you have received are correct but I can easily see why your uncle wold say what he said. It depends on where the funds to pay down the principle came from.
Let's for arguments sake say that you have a totally open mortgage. At some point in the year, you find yourself with funds from some source and decide to use some of it to pay down the mortgage. The pay down is not taxable but source of the funds may be. If it was from a regular job or some other investment, it gets taxed. Its not what you used it for, it is where you got it.
What your uncle probably had in mind is that when you file the tax return for the property, you do need to take into account the principle reduction build into the mortgage payments as income and pay taxes on that. As Jon Holdman pointed out, the principle reduction must be paid with after tax dollars.
Thanks for the info everyone. What about this scenario?
My duplex in CA cash flows at $1,000 per month. I'd like to take $500 and make an extra payment towards principal.
How does the income tax work on a scenario like this, where I am now "technically" cash flowing at $500/mo?
The income will be taxed based on that $1000. What you do with it after that is up to you. Paying down the principal increases your assets and decreases your liability but it will not affect how you are taxed on the actual income you are showing. That is my understanding as of now.
NANA, principal payments are not deductible. If your "net" is $1,000/mo, and your loan payment included $100 principal, your taxable is income is $1,100/mo. Using any or all of the $1,000 to pay down principal is not a deductible expense.
Everyone is correct. Your principal payments are not deductible. You deduct the cost of the building through depreciation.
If your postive cash flow after expenses is 1k per month that does not incorporate what your depreciation is. So you will add back your payment into that 1k cash flow, you will then subtract the depreciation and the interest. That will show you the taxable income/loss
I had a identical conversation with a RE investor who has way more experience than I do and I didn't want to argue something I wasn't sure about but my understanding was the same as the answers given here.
My followup question, He was stating that as an investor we don't want to keep a mortgage deep into its term because the percentage of principal of that payment gets high and our tax deduction becomes lower. He said that you will want to refi and pull cashout every X years to keep your interest to principal ratio high on the payments.
My response verbally was, "Ohh ok I see that makes sense."
In my head I was thinking, "Yes I do see our tax bill would be higher but aren't we earning far more income to compensate for the higher taxes"
The example I play in my head is:
Assumptions:
-1k/month mortgage payment. Our cash flow is 1k/month before debt service.
-Our overall tax rate is 50%.
-year 1 the ratio is $100 principal $900 interest. On Year 10 our ratio is $600 principal $400 interest.
So, Year 1 calc:
pre tax Income= $12000 Tax bill=($1000*12-$900*12)*.5=$600
After tax income=$11400
Principal Paydown= $100*12= $1200
paydown+income=$12.6k
Year 10 calc:
pre tax income= $12000 Tax bill=($1000*12-$400*12)*.5=$3600
After tax income= $8400
Principal paydown=$600*12=$7200
Paydown+income= $15.6k
So the way I see it is you have a larger "current income" earlier in the term because your deductions are higher but every dollar you pay down you increase your assets at double the rate you increase your taxes (tax rate is 50c on dollar)
Which is the correct way of looking at this?
I do see his point that if you refinance to pull out enough cash to now have a $1k payment again your tax bill will be lower again now and you will have extracted equity to invest elsewhere which is superior as long as you earn higher than the interest rate you are paying.
@Zachary Freeman, your Principal is not income, the Principal payment comes from your income, your pre tax income only gets reduced by the amount of the interest you pay and that amount depends on your tax rate then you pay tax on that amount. you are adding your principal payment and income together and that is not right, the $600 in principal payment comes from the $12000 pre tax income.
There have been a lot of responses, some long some short. Let me try a short one:
Rental income is taxable. It doesn't matter if you use it to pay down your mortgage or if you use it to further your collection of life size inflatable dolls.
There have been a lot of responses, some long some short. Let me try a short one:
Rental income is taxable. It doesn't matter if you use it to pay down your mortgage or if you use it to further your collection of life size inflatable dolls.
Yes, I understand that. Yet, paying down your mortgage is valuable by increasing your asset and reducing liability. Whereas inflatable dolls are not financially beneficial. My question isnt what is taxable. My question is,
Does keeping the interest to principal ratio of our mortgage payments beneficial?
Yes, our post tax net income is higher but it comes at a cost of not increasing our equity as fast.
Followup, is it true that we don't want to hold a mortgage note near its maturity because the deductible portion of the payments will be too small and we are better off cash-out refinancing to an equivalent payment size as long as we can produce income on that cash-out equal to the interest rate of the note?
@Zachary Freeman, your Principal is not income, the Principal payment comes from your income, your pre tax income only gets reduced by the amount of the interest you pay and that amount depends on your tax rate then you pay tax on that amount. you are adding your principal payment and income together and that is not right, the $600 in principal payment comes from the $12000 pre tax income.
I understand principal pay-down isn't income. Perhaps it was misleading/incorrect to add them together, but I was more trying to create a term of "change in net worth" rather than imply they were both income. And in this case "Change in net worth"=Income+increase in assets. Even though principal payments are not income, they are increasing your net worth by reducing your liability. At exit that will increase your cash in hand. Perhaps my point is clearer this way:
If our tax rate is X, every dollar of our payment that is interest increases our income by X cents.
Every dollar of our payment that goes towards principal does nothing to our income but it increases our net worth by one full dollar.
Do we want X cents increase in our income, or do we want the full dollar increase in our net worth? If the answer is "X cents increase" than does it make sense to cash-out refi to intentionally keep paying more towards interest. This is what my colleague argued.
However my logic says that my colleague is incorrect and we would always prefer to have a larger "increase in net worth".
An analogy would be do we want an interest only payment of $1k or do we want an interest free loan with payments of $1k? The interest only payment will increase our income but clearly our net worth will not be near as high.
@Zachary Freeman Ok, now i see where you are coming from, yes, as you pay down your mortgage your net worth will increase. in the same sense, you take the equity from the house and use it to purchase another property, you have increased your net worth with the potential of more income from it. so that same amount that you want to sit in your property by paying down the loan and increase your net worth will actually serve you better by taking it and investing in another property ( same amount ) you will increase your net worth and income. hope that makes sense, that is why you have heard that you do not want to keep a mortgage deep into the property, the equity will serve you better by pulling it out and reinvesting it. read this blog i wrote, may help to understand: https://www.biggerpockets.com/blogs/8121/49059-do-...
pre tax Income= $12000 Tax bill=($1000*12-$900*12)*.5=$600
After tax income=$11400
Principal Paydown= $100*12= $1200
paydown+income=$12.6k
Zachary,
In year one, your annual pre-tax income before debt service is $12000. You pay $100 per month in non-deductible principal reduction, giving you a $1200 annual taxable income as you correctly calculated. However, your annual debt service was $12000 so your net cash flow before taxes is $0, and negative $600 after taxes.
In year ten, you are correct that your interest deduction will be lower which increases your tax bill, but your annual pre-tax cash flow is still $0 before taxes. You have a higher net negative cash flow in year ten, if all things remain constant.
Regardless of whether you have an interest only loan or an amortizing loan, if your debt service consumes all of your net operating income, your net cash flow is $0. You have no money to pay the tax bill on any taxable income you may have based on your non-deductible loan principal reduction.
I bring this up because I believe you are focusing on the wrong thing. Focus on cash flow instead of your tax bill. Ideally, you want your after tax cash flow to be positive so the money to pay the tax bill does not come out of your pocket. Instead, the tax bill is paid by your tenants.
pre tax Income= $12000 Tax bill=($1000*12-$900*12)*.5=$600
After tax income=$11400
Principal Paydown= $100*12= $1200
paydown+income=$12.6k
Zachary,
In year one, your annual pre-tax income before debt service is $12000. You pay $100 per month in non-deductible principal reduction, giving you a $1200 annual taxable income as you correctly calculated. However, your annual debt service was $12000 so your net cash flow before taxes is $0, and negative $600 after taxes.
In year ten, you are correct that your interest deduction will be lower which increases your tax bill, but your annual pre-tax cash flow is still $0 before taxes. You have a higher net negative cash flow in year ten, if all things remain constant.
I bring this up because I believe you are focusing on the wrong thing. Focus on cash flow instead of your tax bill. Ideally, you want your after tax cash flow to be positive so the money to pay the tax bill does not come out of your pocket. Instead, the tax bill is paid by your tenants.
I'm not focusing on the wrong thing. The example was a model to simplify the discussion. I would never make an investment that had negative cash flow intentionally.
Ignoring the tax implications would be ignoring my only question. I'm solely interested in looking at the investment late into the note term and seeing if the increased principal paydown is beneficial enough to outweigh the decrease in after tax cash flow.
Secondarily, does this mean we will always want to cash out refinance at some point rather than pay off the note?
Your model always has a negative after tax cash flow, beginning from year one. So, I guess the question becomes whether you eventually want to have a positive after tax cash flow once the property is owned free and clear, or, do you always want a negative after tax cash flow by keeping financing in place.
Assuming you have a fully amortizing fixed rate 30-year loan, it will take 20 years to reduce your principal balance by 50%. At what point in the original loan term to you have enough equity to do a cash out refinance? I suppose if you started with 80% financing on a $190K property you would have enough equity to cash out refinance $25K in about ten years. If you refinanced for the same rate and term as your original loan, you could conceivably do a tax-free $25K cash-out refinance every ten years or so.
Principal pay down on an investment property IS considered taxable income because the principal pay down comes from tenant cash flows. Your uncle was right.
Nick Jerkovich is correct. Here’s another way of looking at it:
The tenant pays you $1,800 in rent, which is fully taxable.
You pay $1,000 in interest which is deductible, reducing your taxable income to $800 (ignore other expenses). You pay tax on this $800 and then use what’s left to pay the principal. You have just used after tax income to pay down your principal.
You have to pay tax on the money you use to pay down the principal