The Annoying "mortgage interest" write off

The Annoying "mortgage interest" write off

Accountant · Member since 2008 · 119 posts · 52 votes

Recently I've heard (or seen) some real estate guys preach and preach and preach about how keeping mortgage debt is good because you don't lose the mortgage interest deduction. This is very misleading to a new investor who may not have a grasp on taxes and tax deductions and how they work.

Let me explain why the mortgage interest deduction is not a good justification for not paying off debt:

The first reason is that 1. Mortgage interest is a DEDUCTION not a credit. A tax credit reduces the taxes due....after you've run your tax calculation if you owe $1000 and you have a $100 tax credit, the tax bill is reduced to $900. This is a direct $1 for $1 write off. Great. Too bad mortgage interest is not a credit, it is a deduction. This means it only reduces your taxable income. Assuming your tax rate is 20% and you pay in $1 of mortgage interest, the deduction would reduce your taxable income by $1. The $1 deduction in taxable income X 20% = $0.20 savings on your tax liability. You're still down $0.80 for that dollar, it's not a wash as some people make it sound.

This next part does not really apply to a properly run rental business because if you're treating it as a seperate business, the mortgage interest is an expense of doing business.

But when talking about your primary residence, I hear uneducated Realtors and bankers suggesting to keep a mortgage to keep the tax deduction. As seen above, you are only saving $0.20 on your taxes for every $1 you pay to the bank. To add insult to injury, the small benefit is only received if you itemize your deductions. If you claim the standard deduction ($11,600 for married couples) then you receive no tax benefit for your mortgage interest paid. What this means is your itemized deductions MUST be more than the default $11,600 deduction to receive any benefit (if married, $5800 if single). So, say your only itemized deduction is $12,000 in mortgage interest, you're good right?! All clear!....well, not really. Sure, you are itemizing, but are you really receiving $12,000 in true deduction? I vote no. I like to look at things incrementally. What i mean is without itemizing, you get $11,600 deduction by default, with itemizing you're getting $12,000 worth of deductions. The true felt benefit is only $400 INCREMENTAL deduction ($12,000 itemized - $11,600 standard) . Now take that $400 and multiply it by the above 20% tax rate and you only save an incremental $80 on your tax liability over the standard. Is that worth $12,000 in interest paid?

What I'm saying here is, the interest deduction is not that sweet and certainly not worth justifying keeping debt if you have the means to pay it off. Lets think of it in terms outside of real estate and taxes, people get in a la la land when they hear tax deduction (i think due to a lack of understanding). Lets think of this in terms of a pizza and a coupon. If I had a coupon that would save you $20 on your pizza, would you pay me $100 for it? The obvious answer is no, so why would you pay $1000 to the bank in the form of mortgage interest to save $200 on your tax liability? If you're going to be giving money away, donate the $1000 to charity instead and you will get the same $200 tax benefit.

That's it for my rant,

D Payne

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J ScottPro Member
Moderator
Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
15y

If the only benefit of holding a mortgage was the interest deduction, there is no argument that the benefit doesn't outweigh the cost (just like you shouldn't get married or have kids just to the tax benefits).

But, just like with marriage and kids, the benefits of mortgages extend well past the tax benefits.

These days, with interest rates so low, any decent investor should be able to earn more than the rate at which he can borrow. The opportunity for basic investing arbitrage is perhaps better than it's ever been or ever will be again in our lifetimes.

Additionally, the benefits of leverage to be able to buy property (or other assets) at the currently depressed rates gives the ability to both dollar cost average and increase cash flow long-term (with the obvious risks of leverage if you use too much of it).

Add these benefits to the benefit of the interest deduction (which is much higher than 20% if you're earning more money, btw), and the overall benefit can be extremely positive.

Again, it's easy to approach this topic with a very narrow and simplistic view, but good investors realize that most things are not simplistic in this world...

See this reply in the discussion

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  • SFR Investor · Orange County, CA · Member since 2009 · 1k+ posts · 1k+ votes
    15y

    It's better to make money and pay taxes on it than not make the money at all.

    Likewise, it's better NOT to spend money at all than spend money and take a deduction for it.

  • Accountant · Member since 2008 · 119 posts · 52 votes
    15y
    Originally posted by Mitch Kronowit:
    It's better to make money and pay taxes on it than not make the money at all.

    Likewise, it's better NOT to spend money at all than spend money and take a deduction for it.

    You get it!

  • J ScottPro Member
    Moderator
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    15y

    If the only benefit of holding a mortgage was the interest deduction, there is no argument that the benefit doesn't outweigh the cost (just like you shouldn't get married or have kids just to the tax benefits).

    But, just like with marriage and kids, the benefits of mortgages extend well past the tax benefits.

    These days, with interest rates so low, any decent investor should be able to earn more than the rate at which he can borrow. The opportunity for basic investing arbitrage is perhaps better than it's ever been or ever will be again in our lifetimes.

    Additionally, the benefits of leverage to be able to buy property (or other assets) at the currently depressed rates gives the ability to both dollar cost average and increase cash flow long-term (with the obvious risks of leverage if you use too much of it).

    Add these benefits to the benefit of the interest deduction (which is much higher than 20% if you're earning more money, btw), and the overall benefit can be extremely positive.

    Again, it's easy to approach this topic with a very narrow and simplistic view, but good investors realize that most things are not simplistic in this world...

  • Property Manager · Farmington, MI · Member since 2011 · 61 posts · 20 votes
    15y
    Originally posted by J Scott:
    If the only benefit of holding a mortgage was the interest deduction, there is no argument that the benefit doesn't outweigh the cost (just like you shouldn't get married or have kids just to the tax benefits).

    But, just like with marriage and kids, the benefits of mortgages extend well past the tax benefits.

    These days, with interest rates so low, any decent investor should be able to earn more than the rate at which he can borrow. The opportunity for basic investing arbitrage is perhaps better than it's ever been or ever will be again in our lifetimes.

    Additionally, the benefits of leverage to be able to buy property (or other assets) at the currently depressed rates gives the ability to both dollar cost average and increase cash flow long-term (with the obvious risks of leverage if you use too much of it).

    Add these benefits to the benefit of the interest deduction (which is much higher than 20% if you're earning more money, btw), and the overall benefit can be extremely positive.

    Again, it's easy to approach this topic with a very narrow and simplistic view, but good investors realize that most things are not simplistic in this world...

    And Mr. Scott takes us to warp speed!!! (sorry, I am a bit ashamed I wrote that but it is April 1st). The benefit os the mortgage interest deduction is NOT an argument for debt directly, the mortgage interest deduction decreases the effective interest rate of debt, meaning if you are paying 5% and have a 20% interest rate, your cost of the debt is really 4%. Now if you have cash sitting around in a CD and can't find anywhere else to put your cash, then yes, pay off your debt. If there is one more profitable real estate project out there where you can return >4% buy the project.

    I wonder how many major real estate companies Mr. Payne thinks carry no debt.

  • Real Estate Investor · Baltimore, MD · Member since 2008 · 1k+ posts · 268 votes
    15y

    Daniel, I am with you on this issue.
    Most BP'ers will however vouch for mortgaging properties in order to increase leverage.
    Do what you think is right.

  • Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
    15y

    Leverage can be good or bad. Using leverage wisely can allow someone to expand their business. The tax deduction is an added benefit of leverage, I would certainly not take on a mortgage only for the tax benefit.

  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    15y

    I believe the OG poster stipulated that he was referring to onwer occupant only, as it is clear that using leverage (debt) on renatls has an advantage in that all the interest paid is deductible and the debt allows the investor to apply leverage responsibly to increase ROI.

    However, I do agree that anyone who states someone should keep a mortgage simply for the reason of the deduction does not understand the numbers as explained by Daniel. It is true that you lose 80% and only benefit 20% of every dollar with such a deduction, however, as Jason eluded to, there are many other factors which can weigh in as a positive for debt leverage on an OO home.

    I for one have a HELOC on my personal residence and pay less than 4% interst on it. I can take that very same money, invest and get an 80% annual return. Did I do it just for the tax deduction? Of course not, the real underlying benefit was the availabilitry of cash to invest at a much higher rate than what it cost me to get the money.

    Banks do this all day long. They take deposits and pay you 1%, take that very same money and loan it out to Mr. Joe Smith for 5% and keep the 4% spread!

  • Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    15y
    Originally posted by Paul OConnell:
    ... The benefit os the mortgage interest deduction is NOT an argument for debt directly, the mortgage interest deduction decreases the effective interest rate of debt, meaning if you are paying 5% and have a 20% interest rate, your cost of the debt is really 4%. ...

    I believe a correction is in order for the word I placed in bold above; that word "interest" should read "tax" IMO.

  • Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    Jason's post is excellent and Paul's post is spot-on too.

    The only thing I would add is that having positive operating leverage and keeping debt on property is one of the only true hedges for inflation as well. If you are borrowing at an after-tax rate of 4%ish and inflation is running at 5%ish the MONEY IS FREE in real terms. You would be foolish to pay this debt off IMO. Borrow prudently and place the equity in other projects that yield a higher overall ROE for your portfolio.

  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    15y
    This is exactly what I stated in my post and is the underlying premium benefit to keeping debt on the property, assuming the owner/investor is savvy enough to invest for better returns than the cost of the loan.
  • Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    The primary reason I keep debt on my long-term product is for the inflation hedge Will. Stuffing the equity in more projects is a close 2nd for me.

  • Investor · Westminster, CO · Member since 2009 · 1k+ posts · 1k+ votes
    15y

    Another way to look at this is the FACT that everyone needs a "roof over their heads." If you are going to have to pay $1,000.00 in rent, why not pay a $1,000.00 mortgage payment? At 5% and a 30 year Amort Schedule, a person can borrow $186,000.00. If you want a $500.00 mortgage payment, you can borrow $93,000.00.

    Forget leverage, mortgage interest deduction, ROI, inflation hedge, etc..... With a mortgage, you are "rent free" in 30 years vs paying rent FOREVER. Paying your mortgage off early is a great benefit, not only can you live "rent free" earlier, you now have a source of money for investments that may come your way, like Will uses his HELOC.

    While I agree that using the "mortgage interest" argument for keeping a mortgage is weak, as others have posted, having no mortgage may not be the "highest and best" use of one's assets.

  • Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
    15y

    The ability to use home equity to purchase investments with low interest long term debt can be a great way to build wealth. The tax deduction means little. Leverage needs to be used wisely, but it can bring about nice returns.

  • Investor · Lucas, TX · Member since 2010 · 620 posts · 352 votes
    15y
    Originally posted by Will Barnard:

    Banks do this all day long. They take deposits and pay you 1%, take that very same money and loan it out to Mr. Joe Smith for 5% and keep the 4% spread!

    Err that is not how it works. They take a $120 deposit (paying you 1% if your lucky) and then loan Mr. Joe $1200 at 5%. The $1080 difference is created out of thin air. Welcome to fractional reserve banking.

    So they pay you 10c interest per month but collect $5 per month in interest on the loan. What is the spread there?

  • J ScottPro Member
    Moderator
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    15y
    Originally posted by Robert Steele:
    So they pay you 10c interest per month but collect $5 per month in interest on the loan. What is the spread there?

    So, they earn 50 times the rate at which they borrow?

    I routinely do the same thing on my flips. I borrow at about 6% and repay a couple months later after making 50-100% on my investment, which translates to 300-400% annualized return (or about 50 times the rate at which I borrowed).

    Leverage for the sake of investing arbitrage is a wonderful thing... :D

  • Investor · Fort Worth, TX · Member since 2011 · 1k+ posts · 450 votes
    14y

    If you have a mortgaged property and a clear property; if each property has an equivalent monthly cash flow, the mortgaged property will be less of a tax burden at the end of the year, therefore yielding a higher effective cash flow.

  • Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Brian,

    You may pay taxes on the money; however, you're probably still very much ahead. You're wrong. Those two properties you are comparing are not equal. Take the same 100k property, one free and clear and the other mortgage. Free and clear will ALWAYS yield a better return. The mortgaged may have an interest deduction; however, I'd rather not waste money on interest unless I can use that money to earn a higher rate of return.
    I'd rather make the $100 and pay 25% in taxes than only make 50 and pay 25% in taxes on that.

    -Steven the Tax Guy

  • Investor · Fort Worth, TX · Member since 2011 · 1k+ posts · 450 votes
    14y
    Originally posted by Steven Hamilton II:
    Brian,

    You may pay taxes on the money; however, you're probably still very much ahead. You're wrong. Those two properties you are comparing are not equal. Take the same 100k property, one free and clear and the other mortgage. Free and clear will ALWAYS yield a better return. The mortgaged may have an interest deduction; however, I'd rather not waste money on interest unless I can use that money to earn a higher rate of return.
    I'd rather make the $100 and pay 25% in taxes than only make 50 and pay 25% in taxes on that.

    -Steven the Tax Guy

    Steve, I said two houses with equal cash flow each month, not equal value.

    For example:

    House A
    Free and clear
    Gross rents = 600/month
    All expenses = 300/month
    Net cash flow = 300month
    Mortgage tax deduction = 0

    House B
    With Mortgage
    Gross rents = 1500/month
    Expenses = 600/month
    Debt Service = 600/month
    Net cash flow = 300/month
    Mortgage tax deduction = something

    House B has a higher effective cash return after taking the tax deduction into account.

    Obviously, both houses can't cost the same amount to purchase, but this is a realistic thing to consider if you have $30K in hand and you are contemplating buying a low income unit all cash, or putting a good down payment for a house that costs four times as much. In each case, you *may* be looking at the same cash flow, but in one case you have other benefits such as the tax write-off, not to mention higher mortgage pay down and higher odds for potential for appreciation.

  • Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Brian,

    You are comparing apples to oranges. The point is to compare them on the same property: whether you want it paid off or mortgaged.

    Also you aren't comparing the fact that in the financed scenario your payments will not be 100% interest; they will contain principle as well so you won't have as high of a deduction as you think, so you may be paying tax on more income.

  • Investor · Fort Worth, TX · Member since 2011 · 1k+ posts · 450 votes
    14y
    Originally posted by Steven Hamilton II:
    Brian,

    You are comparing apples to oranges. The point is to compare them on the same property: whether you want it paid off or mortgaged.

    Also you aren't comparing the fact that in the financed scenario your payments will not be 100% interest; they will contain principle as well so you won't have as high of a deduction as you think, so you may be paying tax on more income.

    Truly Steve, I understand what you are saying.

    Howver, I am stating that given the same *cashflow*, a property where you pay interest on a mortgage (even the interest being part and not all of the payment) will have a higher *effecitve* cash flow. I made no comments as to the magnitude of the difference. Yes one house is an apple and one house is an orange. But cash is cash. That is why I put my expamples to illustrate my thinking. Then I followed up with further comments indicating property A would be more like a cash owned 30K property and house B would be more like a 120K house with a 30K DP applied to it.

    I do not think for a second to know more about tax code and law than anyone. But I do understand basic concepts and what I am talking about here is a simple application of math and multiplication. Either you aren't reading what I am writing carefully enough, or I am not writing it in a way that is clearly communicating what I am trying to get across.

    FWIW, I am not advocating anything here. In fact, I still was better off claiming standard deductions for myself and my wife this year despite having one house with a mortgage and having purchased a cheap rental as well this year. So, I understand that that mortgage interest might not benefit you as a write off at all. But, if your expenses exceed the standard exemptions, then it will, even if just a little.

    Also, maybe your point is to make this analysis given the same property, but that is not my point. My point is comparing *differnt* options given the oppertunity to invest the *same* money (abouut 30K in my example) in different ways that effect your tax benefit differently.

  • Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Brian,

    I agree that the funds can leveraged to increase overall return on investment. I want to mention though that in your cash flow statements of them being equal you will have more taxable cash flow with the mortgage than the same cash flow without financing. This is because of the principal payments in the financing. I will agree and I prefer leveraging.

    -Steven the Tax Guy

  • Investor · Fort Worth, TX · Member since 2011 · 1k+ posts · 450 votes
    14y

    Steve, you make an excellent point that I did not consider. Income taxes would be based on gross rents and the total gross rents from the bigger property would be much higher, and only a portion of which would be deductible. In retrospect, I think you were saying that earlier and I actually did not understand what you were saying.Very good point. Thank you for that. You get my vote!

  • Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Brian,

    Yes that was my point earlier. I have a spreadsheet I can send you that shows the difference.

    -Steven the Tax Guy

    Your guide to IRS laws, rules and regulations

  • Investor · CA · Member since 2010 · 150 posts · 40 votes
    14y

    Steven,

    I'd be interested in the spreadsheet also :o).

  • Commercial Real Estate Lender / Syndicator · Dallas, TX · Member since 2011 · 888 posts · 309 votes
    14y

    Steven, can you post the spreadsheet to FilePlace (found under Resources in the menu).

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