Paying off my rental properties - tax implications

[sbaTexas]

I'm thinking about paying off my 3 rental properties.  With the cash I have laying around I could pay off 1 today, then use the rental cash flow to have them all paid off over the next 3 years.  My question is what tax benefits would I be giving up doing this?  My interest rates are 4.125, 3.25, and 2.875%.  This year im on pace to pay $5,200, $5,498, and $4,226 in mortgage interest, respectively.  Would the mortage interest deduction for taxes be enough to warrant keeping the mortgages?  What all am I not considering?  Thanks in advance!

[TheOldestYoungMan]

My understanding of this is entirely academic.  I buy my first pure rental property here in a few months.

Your specific situation is going to be something you have to figure out for yourself, but here's how you go about it.

Right now, you have a certain amount of rental income.  You are able to offset that rental income by deducting your rental expenses.  That's everything except for the principal part of the mortgage payment.  So...

Property taxes, insurance, gas, sewer, water, property mgmt, yard, any maintenance, phone, business related expenses, and depreciation on the house.

You add all those up (can use numbers from last year).

Then figure out what tax bracket you are in (and are going to be in).

The only change to you is going to be reducing that deductible amount by that mortgage interest.

Let us just assume you are in the 25% tax bracket.

You used to have (x+$15k) roughly in deductions.  Now you only have x deductions.

So you will pay 15*.25 or $3,750 more in taxes, but you'll have 15k in income not going towards the taxes.  So you end up positive $11.25k in terms of cashflow.  And also, you know, in terms of net worth (it is a real gain).

But wait!

It takes additional capital investment to eliminate those mortgages, so we need to look at the opportunity cost.  I'm going to ballpark your outstanding mortgage balance at [a lot].

But I'm also going to note that you have "cash laying around" that can pay off five thousandish in interests worth of principal at maybe 4.12 (which is what 130k or so?  That's nuts!), and say that you just keep tons of cash laying around.

So your opportunity cost is relatively low, and so likely you'll be better off.

There's also a risk reduction factor to be considered by eliminating debt, such that it is usually worth considering if there are only marginal opp cost considerations.  As in, vacancy still impacts your total returns, but it is a lower risk to your month-to-month solvency.

But yea, this can get very complicated, and you're going to want to look at what your return on capital is before and after.  In some cases it is going to be much improved, and in some it would actually be worse.

The advantage a FIRE minded person might think about in paying off, is that if you were barreling towards FIRE and getting close, once you no longer have a regular gig income, and you get down to the 10% or 15% bracket, the deduction is worth less.  Particularly if you were to pick up a RE license and got to treat the rentals as cap gains income instead of earned (which may be something I just made up and not a real thing).

[Alternatepriorities]

It depends a lot on how much peace of mind having those properties paid off gives you. I usually think of things in terms of the effective or net rate after taxes. With three rentals it is safe to assume you're at least in the 25% tax bracket? If so, the tax deduction effectively reduces the interest rates to 3.09%, 2.44%, and 2.16%... Personally I'm willing to bet on better VTSAX returns than that over the life of mortgages, but I know maybe people would rather be debt free than take a little risk to likely make more money. I also see paying off a mortgage as concentrating risk in a single investment.

[hendlefe]

Your effective interest rates are pretty low. If it was me, I would invest in stock market instead. If you want, you could pay off only the highest interest property.

Think about the risk of having properties fully paid off. For one, all your eggs will be in one basket. If something happens to the real estate market in your area, it may be difficult and time consuming to recover.

[With This Herring]

Possibly ignorant idea from someone who owns no rental property:
If you have that much cash, why not buy more rental property?

[sbaTexas]

Thank you all for the responses.  I guess I should add that were I to pay these off, it would make my real estate portion of my net worth about 50% of overall net worth number. .. so I already have a fairly substantial position with index funds.  I guess that's why im not as worried about the "eggs in one basket" dynamic.

And yes, I have been looking to purchase more with this cash but I'm finding it next to impossible to find good deals with the current sales prices being what they are. 

I know the math tells me I shouldn't pay them off but lately im becoming more intrigued with the idea of simplifying and being debt free. . .let alone the added monthly cash flow.

[Drifterrider]

I read your question as this:

Should I continue to give the bank $1 in order to avoid giving the IRS $0.25?

The best debt is no debt. 

[Taran Wanderer]

Are you trying to maximize the dollars you pocket each month from the rentals, or do you want to maximize return on equity?  If the former, pay them off. If the latter, use your additional cash to buy more rental properties and continue to make money on the bank's portion of your investment.

[hendlefe]

It seems as if you are leaning towards paying off the properties. It's not necessarily wrong which direction you go with your excess cash, as long as it's being used as an investment. You could just pay off the properties, then get a line of credit (without withdrawing any cash out) on all of your properties from a good bank or credit union. That way, you will be poised to pounce on any good real estate deals that may cross your path.

[Vinivedivichi]

In short, from a pure tax perspective it's not a great idea.  The interest your paying is deductible so you are getting a 25% or so haircut on the combined say 3.5% interest rate - that means you're paying about 2.6% interest after taxes.  That is an extremely cheap borrowing cost.  Note also that this payoff analysis is a bit different for investment property than for individual property since if this was an individual property you have the benefit of the standard deduction if you have no interest deductions.  But in this case since it's a business expense it's deductible dollar for dollar.

At the end of the day you're still paying a net 2.6% interest, though.  While that is in theory an expense you don't have to incur if you have the cash to pay off the notes, if you pay off the homes you are "accepting" a 2.6% return on your cash, which is pretty low.  You could keep the loan and invest your cash and likely come out ahead.  You could also buy additional properties.  But if owning the properties free and clear is what you want and maximizing the return on your capital is not necessarily the primary driver, then paying off the mortgages could make sense. 

For what it's worth, I paid off my personal mortgage and I'm very happy with the decision.  However, I'm not sure I would do the same with a business property. 

[zephyr911]

Don't keep the mortgages just to pay the interest and reduce taxes. Keep them so you can put that cash to better use and grow your asset base. Staying leveraged increases the returns you can earn without having taxable income, primarily due to depreciation; the interest is secondary.