Author Topic: Pay off an investment property's mortgage?  (Read 3618 times)

slurpingturtle

  • 5 O'Clock Shadow
  • *
  • Posts: 3
Pay off an investment property's mortgage?
« on: January 11, 2016, 07:51:15 PM »
Hello Mustachians!

We are currently working and are just 2 years away from FI.

A large part of this plan is our two investment properties:
* a triplex that we recently purchased from slum lords and rehabbed ourselves (4.75% apr)
* a duplex we purchased several years ago (3.5% apr)

We also have a mortgage on our own house (3.75% apr).

Here's the deal: we have enough cash on hand to pay off the triplex's mortgage.  If we pay that loan off, we'll get about 10-11% annual return on that money after property taxes, insurance, and expenses and we'll get rid of our highest-interest loan.

Should we do this?
Are we missing tax implications?
Is there some other short or long term opportunities for this money that we haven't thought of? 

Other things we know we could do with the money:
1. invest it in mutual funds and get ~5-7% return
2. buy more investment properties (though to be honest, we'd rather not have more tenants, 5 is enough)
3. ???

Vagabond76

  • Stubble
  • **
  • Posts: 225
  • Age: 43
  • Location: Destin, FL
Re: Pay off an investment property's mortgage?
« Reply #1 on: January 11, 2016, 08:33:25 PM »
Two things:

1.  100% of a rental property loan's interest is deductible. The deduction for a personal house's loan is only economical after it and other itemized deductions exceed the standard deduction.

2.  The interest deduction on rentals is an above-the-line deduction that reduces AGI. This may have other tax implications as so many other things phase out after a certain AGI.

slurpingturtle

  • 5 O'Clock Shadow
  • *
  • Posts: 3
Re: Pay off an investment property's mortgage?
« Reply #2 on: January 11, 2016, 08:42:14 PM »
@Vagabond76:
post-FI, our plan is dropping at least one of our day jobs, thus reducing our income greatly.

I guess we need to do math to figure out what the difference in taxes is before and after FI and I now see that I need to readjust the ROI calculations to account for the tax implications of losing the mortgage's interest deduction.

slurpingturtle

  • 5 O'Clock Shadow
  • *
  • Posts: 3
Re: Pay off an investment property's mortgage?
« Reply #3 on: January 11, 2016, 09:06:42 PM »
I just re-did the ROI calculations to account for a pre-FI tax rate of 25% and a post-FI tax rate of 15% (for simplicity), and the ROI is still pretty nice...

After payoff, pre-FI, we'd make about 8.7% annual returns, after taxes
After payoff, post-FI, that's about 9.7% annual, after taxes

What I'm seeing is that the tax benefit of having a mortgage is completely swamped by the increased cashflow without a mortgage - currently 2/3ds of the rent paid by my tenants goes to pay the mortgage, insurance, etc.  After paying it off, only about 1/3 of rent will go to paying insurance, taxes, etc.

Vagabond76

  • Stubble
  • **
  • Posts: 225
  • Age: 43
  • Location: Destin, FL
Re: Pay off an investment property's mortgage?
« Reply #4 on: January 11, 2016, 09:43:41 PM »
We will never be in less than a 25% marginal tax bracket, even post-FIRE. Of course, we always pay less than 10% in effective tax rates.

Drifterrider

  • Handlebar Stache
  • *****
  • Posts: 1118
Re: Pay off an investment property's mortgage?
« Reply #5 on: January 12, 2016, 05:27:47 AM »
For those who think having a mortgage (paying interest) is a tax benefit consider this.

You pay interest: you don't pay taxes on the interest but you've paid the interest.

You don't pay interest:  you pay slightly higher taxes but you keep more of your money in your pocket.

No interest, pay taxes:  you pay less and keep more.

If you can afford to be out of debt without cutting yourself short, get out of debt.  Pay yourself the interest.  Use your last year's tax forms.  Recalculate your position with and without interest.  Now think of having all that interest in cash in front of you.

I've never met anyone yet who was in a better position giving away $1 so he could keep $0.25.

matchewed

  • Magnum Stache
  • ******
  • Posts: 4381
  • Location: CT
Re: Pay off an investment property's mortgage?
« Reply #6 on: January 12, 2016, 06:56:43 AM »
Longterm mortgages are great inflation hedges.

zephyr911

  • Magnum Stache
  • ******
  • Posts: 3624
  • Age: 42
  • Location: Northern Alabama
  • I'm just happy to be here. \m/ ^_^ \m/
    • Pinhook Development LLC
Re: Pay off an investment property's mortgage?
« Reply #7 on: January 12, 2016, 07:03:17 AM »
I'd be less concerned with tax implications than total returns. How much will you be taking home when all your rentals are free and clear? Would you be better served by dropping that cash into a down payment on more property and deleveraging later? Or are you so close that all you need to do is eliminate debt service?

I don't plan on paying anything off any sooner than necessary - maybe the final 6-12 months before I quit completely.

Vagabond76

  • Stubble
  • **
  • Posts: 225
  • Age: 43
  • Location: Destin, FL
Re: Pay off an investment property's mortgage?
« Reply #8 on: January 16, 2016, 08:28:12 AM »
For those who think having a mortgage (paying interest) is a tax benefit consider this.

You pay interest: you don't pay taxes on the interest but you've paid the interest.

You don't pay interest:  you pay slightly higher taxes but you keep more of your money in your pocket.

No interest, pay taxes:  you pay less and keep more.

If you can afford to be out of debt without cutting yourself short, get out of debt.  Pay yourself the interest.  Use your last year's tax forms.  Recalculate your position with and without interest.  Now think of having all that interest in cash in front of you.

I've never met anyone yet who was in a better position giving away $1 so he could keep $0.25.

We have enough gross income to put us in the 39.6% tax bracket + the 3.8% Obamacare surcharge.  Real estate deductions and exclusions help us get down to the 25% bracket with no surcharge.  Our cash flow return on real estate debt is 7%.  In other words, I may "give away" $1, but it (1) allows me to earn $1.07 and saves me $0.44 in tax.

I've never met anyone yet who is not in a better position giving away $1 so he could keep $1.51.

GGNoob

  • Pencil Stache
  • ****
  • Posts: 726
  • Age: 33
  • Location: Colorado
Re: Pay off an investment property's mortgage?
« Reply #9 on: January 16, 2016, 09:52:01 AM »
If I was into real estate (I'll stick to my REITs), I'd keep the loans and use cash to keep purchasing new properties. But I'd hire a property management company to take care of everything for me. Reduces my cash, but prevents a lot of work and headaches.

But if you aren't into that, I'd just invest the money. No need to pay off the mortgages early in my opinion. Maybe you could refinance the triplex to a 3.x% rate?

seattlecyclone

  • Walrus Stache
  • *******
  • Posts: 5299
  • Age: 35
  • Location: Seattle, WA
    • My blog
Re: Pay off an investment property's mortgage?
« Reply #10 on: January 16, 2016, 09:58:35 AM »
Here's the deal: we have enough cash on hand to pay off the triplex's mortgage.  If we pay that loan off, we'll get about 10-11% annual return on that money after property taxes, insurance, and expenses and we'll get rid of our highest-interest loan.

I don't think you are properly calculating the return on this money. You already have the rental property and it is bringing in a certain amount of revenue. This is the case whether you pay off the loan or not. By paying off the loan, the only things that change are that you no longer pay interest on the loan and you no longer get to deduct the loan on your taxes. The net effect of this would be that you get an annual return that is slightly less than the interest rate on the loan. (1 - your tax rate) * (interest rate), to be precise.

Retire-Canada

  • Walrus Stache
  • *******
  • Posts: 7741
Re: Pay off an investment property's mortgage?
« Reply #11 on: January 16, 2016, 10:32:15 AM »
Longterm mortgages are great inflation hedges.

+1 - Yes.

I was all set to pay down my mortgage super fast when I realized that my current interest rate is around 1% higher than inflation and I'd much rather put extra money in the market.

I did shorten my amortization period from 25yrs to 20yrs just so I would be in a slightly better position [variable rate mortgage] should interest rates go sharply higher.

I also put the extra money I saved in a tax free investment account that I can withdraw from tax and penalty free any time. That should mean that I can pay down the mortgage as rapidly as I would have if I had lowered the amortization to the max I could afford. Assuming I don't want to do so at the bottom of a market crash.

I agree with the other poster that suggested if you want use that extra cash for something real estate related buy another rental property or two. You'll get a way better bang for your buck than killing you existing rental property mortgage.

I would be tempted to invest that money in the market myself.

Jim2001

  • Stubble
  • **
  • Posts: 203
  • Location: Los Angeles, CA
Re: Pay off an investment property's mortgage?
« Reply #12 on: January 16, 2016, 03:34:05 PM »
SlurpingTurtle,

  First, congratulations on the progress towards FIRE.  IMHO, when looking at paying a mortgage early, there are a few things to consider.  First, how diversified is your overall portfolio?  If the bulk of it is these properties, consider if you really want to tie up a the remainder of your liquid assets.  If you have some sort of emergency, real estate is among the least liquid investments and can only be accessed via a loan or sale.  A number of years ago, I met a school teacher who had amassed eight rental properties while working and was living a comfortable retirement with the rental income supplementing his teacher's pension.  Then the Northridge earthquake hit.  He suddenly had eight un-inhabitable buildings in need of significant repair.

If you've got "extra" money, consider investing in something else (REITs, bonds, low cost etfs, etc.).  You can invest for your choice/mix of security, income and/or growth.  In many cases you should be able to at least match the interest being paid on the mortgages.