Pay for rental property in cash or get a mortgage?

[NeonPegasus]

I'm weighing the pros and cons of purchasing a rental property in cash.

It's listed for $75k. Currently renting for $1.3k/mo.

If I get a mortgage, it would be something like $60k for 15 yrs at 4.375%, which is $455/mo.

DH has $50k in a taxable account. Other investors are sniffing at the property and I'm thinking it would put us in a good position to offer cash.

Let's say I lowball and offer $65k cash. Then, I take $455/mo and invest it every month (yes, I am disciplined enough to do that). Essentially, I'd be paying the mortgage to ourselves for 15 years.

The benefits of doing this would be not paying interest on a mortgage ($22k savings), saving $10k on the initial price and not paying so much on closing costs ($1500 savings). The downside would be losing a tax deduction on the mortgage cost ($20.5k over 15 years, assuming 25% marginal rate) and losing some interest since that $50k wouldn't be fully invested over that period.

Since the $455/mo payments total more than $50k over the life of the mortgage, I'd actually come out ahead in the investment account. Assuming a 6% annual return, I'd be about $10k ahead after 15 years. All together, paying cash looks like it'd save $23k over 15 years.

What am I missing? That doesn't seem quite right. It seems like financing would have some benefits I'm not coming up with.

[Thoughtful Mule]

A lot of people will acquire their deals with cash, then finance to pull money out for other investments.  Using leverage can increase your returns, but also adds an element of risk.  That is up to you.

[jmusic]

On LivingStingy, another frugal blog I frequent, the author did a piece on this very topic (although his example was using automotive financing). 

http://livingstingy.blogspot.com/2015/01/pay-off-debt-or-invest-whats-difference.html

TL;DR:  Given an identical risk free rate of return for investments as the cost of financing, your two scenarios are exactly the same.  Of course, I don't know of any sources for a 4.375% return with zero risk, so your higher returns are from bearing market risk.

Also, the analysis ignores tax treatment.  Interest expense on a rental is tax deductible and can even shield other income from taxes. 

Like Thoughtful said, cash upfront could help you get the deal in the first place.  However, any equities you sell from the taxable account would be taxed, so there's that factor too... 

[Mazzinator]

I think you calculate cash on cash returns... I don't think it matters how much interest you pay...

Rent $15,600 yr gross
$7,800yr net (50% rule, for ease of math)

With mortgage..

$15k down payment
$3k closing costs

$18k total

7,800-5,460 mortgage = $2,340 profit
$2,340/$18k = 13%

No mortgage...

$65k cash
$1,500 closing

$66.5k total
$7,800/$66.5k = 12%

I'm sure someone will correct me if i'm wrong!!!

ETA:
The biggest benefit of having a mortgage, is you could buy 3, for the same amount of money. And, still have $12.5k "left over" for emergencies/oh shit fund.

$18k x 3 = $54k
$66.5k-$54k = $12.5k

$2,340 x 3 = $7k yr

[NeonPegasus]

So here's where things stand today ...

I made an offer, in cash.

The other buyer has offered 72k. I offered 74k, hoping that the other buyer requires financing whereas I don't. We'll see what develops.

To speak to some of the points raised:
1. Yes, it will take a lot of cash but we still have extra for emergencies. We have family partnerships that distribute a few times a year so the next distribution we receive will go straight into the emergency fund, as will all income from the rentals. And if need be, my father in law has offered to loan us what we need in the interim. Truly, we are lucky to have so much financial support.

2. Yes, financing would allow us to purchase more properties; however, I also think owning one good property outright will end up benefiting us more in the future. Here's why: DH and I are self-employed so income can be variable and somewhat hard to prove. We plan on saving the money from the partnerships for another down payment. When we have enough for another purchase, we will definitely have to go to the bank for a loan. At that point, we won't have a large mortgage outstanding. Rather, we will have a free and clear source of income. That ought to help us with leverage in the future. Also, there really weren't a lot of good deals around. I ran the numbers on 20 different properties in the county and few were decent investments. So, even if I had money to make more offers, I'm not sure I'd find anything I'd want to buy!

Anyway, here's hoping the seller accepts our offer!

[Overseas Stache]

So here's where things stand today ...

I made an offer, in cash.

The other buyer has offered 72k. I offered 74k, hoping that the other buyer requires financing whereas I don't. We'll see what develops.

So yesterday you said you were thinking of offering 65K and today you offered 74k?

[NeonPegasus]

So here's where things stand today ...

I made an offer, in cash.

The other buyer has offered 72k. I offered 74k, hoping that the other buyer requires financing whereas I don't. We'll see what develops.

So yesterday you said you were thinking of offering 65K and today you offered 74k?

Honestly, I doubted I would offer that low.  10,000 off $75,000 asking price is pretty extreme. That was just a little daydreaming on my part and didn't make a material difference in the discussion anyway.

[jmusic]

So here's where things stand today ...

I made an offer, in cash.

The other buyer has offered 72k. I offered 74k, hoping that the other buyer requires financing whereas I don't. We'll see what develops.

To speak to some of the points raised:
1. Yes, it will take a lot of cash but we still have extra for emergencies. We have family partnerships that distribute a few times a year so the next distribution we receive will go straight into the emergency fund, as will all income from the rentals. And if need be, my father in law has offered to loan us what we need in the interim. Truly, we are lucky to have so much financial support.

2. Yes, financing would allow us to purchase more properties; however, I also think owning one good property outright will end up benefiting us more in the future. Here's why: DH and I are self-employed so income can be variable and somewhat hard to prove. We plan on saving the money from the partnerships for another down payment. When we have enough for another purchase, we will definitely have to go to the bank for a loan. At that point, we won't have a large mortgage outstanding. Rather, we will have a free and clear source of income. That ought to help us with leverage in the future. Also, there really weren't a lot of good deals around. I ran the numbers on 20 different properties in the county and few were decent investments. So, even if I had money to make more offers, I'm not sure I'd find anything I'd want to buy!

Anyway, here's hoping the seller accepts our offer!

I don't have the kind of capital that you do, but IMHO the optimal plan would be to buy 3-4 properties with loans and shunt all the excess cash flow into one property's loan until it's paid off.  Rinse and repeat.

[escolegrove]

I think your reasons for going cash make sense! We are buy and hold investors who LOVE leverage! That being said we have VERY stable W2 jobs, and that is how we leverage our stability. If you decide to continue to grow your portfolio than you will be able to do a mix of of cash and leverage. Giving you a great position on those "lean" times of self employment!

[Robert Platt Bell]

On LivingStingy, another frugal blog I frequent, the author did a piece on this very topic (although his example was using automotive financing). 

http://livingstingy.blogspot.com/2015/01/pay-off-debt-or-invest-whats-difference.html

TL;DR:  Given an identical risk free rate of return for investments as the cost of financing, your two scenarios are exactly the same.  Of course, I don't know of any sources for a 4.375% return with zero risk, so your higher returns are from bearing market risk.

Also, the analysis ignores tax treatment.  Interest expense on a rental is tax deductible and can even shield other income from taxes. 

Like Thoughtful said, cash upfront could help you get the deal in the first place.  However, any equities you sell from the taxable account would be taxed, so there's that factor too...

Bear in mind also, that rental properties can be a useful way to convert Ordinary Income into Capital gains - which are taxed at a rate far less than Ordinary Income.   How does it work?  The miracle of the Depreciation Deduction.

See:

[MOD NOTE: Personal blog links removed.  Please see forum rules on spamming/promotion.]

When I was making six figures, having rental properties cut my tax bills considerably.   I had to pay capital gains taxes later on, on the amount depreciated, but this was a tax deferred, and paid at a far lower rate than my ordinary income rates at the time.

Oh the hoops we jump through to live our lives by the tax code.   That is why, I think, the real estate market went crazy in the 2000's (in part, of course).   A lot of folks were looking to buy properties and depreciate them and then write off the deprecation on their taxes.

FWIW!

[sokoloff]

If the tax code actually worked the way that livingstingy blog post suggests it did, it would be great. The code doesn't allow you to depreciate rental property over 10 years and the depreciation recapture is not taxed at 15% LTCG rates as the blog suggests.

That blog post sounds right enough to lure people in, but it's off by about (maybe a little over) a factor of 2 on the tax benefits, which is meaningful. And of course, they block comments, so it stands uncorrected...

[Blindsquirrel]

  FYI, Real estate depreciation is on a 27.5 year scale and only the structure counts. Not the lot. Also, passive losses phase out at 165K AGI for RE investments and the standard for active investor is quite high. When you sell the nasty part of the tax code is recapture of depreciation. The depreciation is added to the value whether you claimed it or not.  If you sell an appreciated property, sell it on a 1031 exchange and roll the gain into the next property. This will defer taxes and in my case, I will hold the new property until I kick the bucket. Then the cost basis will step up to the value when I die. Just my opinion.

[LiveLean]

We had a hard time getting a mortgage for our second home/seasonal rental property. It didn't help that I'm self-employed.

In the end, we took out a mortgage on our primary residence (that we had paid off years ago) and paid cash for the second home/rental property, which we also view as our future retirement home. Much easier to get a mortgage on a primary residence and it's much cleaner from a tax and accounting standpoint, too.

[jmusic]

  FYI, Real estate depreciation is on a 27.5 year scale and only the structure counts. Not the lot. Also, passive losses phase out at 165K AGI for RE investments and the standard for active investor is quite high. When you sell the nasty part of the tax code is recapture of depreciation. The depreciation is added to the value whether you claimed it or not.  If you sell an appreciated property, sell it on a 1031 exchange and roll the gain into the next property. This will defer taxes and in my case, I will hold the new property until I kick the bucket. Then the cost basis will step up to the value when I die. Just my opinion.

Depreciation recapture isn't "nasty," it's merely the government finally collecting taxes from the benefit you've received.  People may consider it nasty because in some circumstances it can exceed the "realized" gain from the sale.  Besides, I view DELAYING taxes (which is what depreciation in effect does) as second only to total avoidance, because you have the use of "the government's" money for a period of time.  As Mr. Bell mentioned (welcome to the forums by the way if it's really you!), the recharacterization of income is a huge benefit as well. 

EDIT:  Just found out that BlindSquirrel is correct.  Recaptured Depreciation IS ORDINARY INCOME. 

Straight from the horse's mouth:
http://www.irs.gov/pub/irs-pdf/p544.pdf

Beginning of pg. 27, Chapter 3

When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any remaining gain is a section 1231 gain.

[Bob W]

Seems like a deal.   As one caller suggested -- pay cash, season it,  cash out finance.  You may be able to pull 80K out of that property, assuming it refis at 100K.   

[zinethstache]

Looking ahead for when you purchase #2, you will only be able to count 75% of your rental income, some lenders will not count if for 2 years, both of my lenders were very lenient and counted my first rentals income for #2 which we acquired only six months later. It is a nice addition in either case and will boost your Self Employment income which will be nice. I think this strategy will work best for you.

Dont forget that your rental's appliances, furnaces, roofs all depreciate as well, not at 27.5 years, they have their own schedule.

Also, when you do finance your first property, research buying points down. Those and your loan origination fee are first year write offs. I am in the buy points school as I want the best bang for the buck (I am a buy and hold investor). So far this buy down strategy has really worked well for me since we've been in the accumulation phase the last few years.

It amazes me that I now think of buying property akin to buying a car. I am no longer nervous or intimidated. I have all my paperwork at the ready, I keep our financial details current at all times. It takes so long to actually be the chosen PSA that when it happens it seems to go very fast.

Having extra financial support is very nice, we too have some extra sources of money, just in case something awesome pops up. Always have your sources identified with how much is available, I update my spreadsheet every couple of months.

Good luck!

[Blindsquirrel]

  Yes, it is a nasty bit of the tax code. If your property goes up and you have depreciated it for 20 years, selling it is a huge tax event. If you have no gain in value in 20 years and you sell it is a huge tax event. Sorry but the government does not take on any risk in this deal and always wins. Do the feds pay my real estate taxes, insurance and repairs? Nope but they sure have their hands out when I sell.