Pay off rental property mortgage?

[Ted_Graham]

When we moved a couple years ago, we kept our old house as a rental. The mortgage is 5.75% for 30 years. I just refied our new house at 3.5% for 5 years.

We have some extra money and I'm considering paying off or down one of these two mortgages. My inclination is to pay off the rental's mortgage, since it is at a much higher rate.

Are there tax reasons to keep a mortgage on the rental property?

[jIM_Ohio]

When we moved a couple years ago, we kept our old house as a rental. The mortgage is 5.75% for 30 years. I just refied our new house at 3.5% for 5 years.

We have some extra money and I'm considering paying off or down one of these two mortgages. My inclination is to pay off the rental's mortgage, since it is at a much higher rate.

Are there tax reasons to keep a mortgage on the rental property?

Yes there are tax reasons to keep mortgage
you need to weigh those against a higher cash flow

the tax reason is that 100% of mortgage interest on a rental is deductible (its a business expenses).

If you would only be paying down the debt, I say pay off the home residence first (so the house you live in is free and clear) as a way of lowering your risk.

If you could pay OFF the rental unit, then pay it off- here is my logic

If you have rental income of $800/mo and monthly expenses of $700/mo on the rental you have $100/mo free cash flow.

If you paid DOWN the rental, those numbers don't change
If you paid OFF the rental (as in no mortgage at all) you would have rental income of $800/mo and minimal expenses (for property taxes) like $150/mo so more free cash flow and a better ROI on the money immediately.

Rentals are about ROI- so if you put money into a property you do not own, you want to see an immediate return on that money to make rental more profitable.

[bjl584]

I agree unless tax laws change. There is talk of eliminating the personal mortgage deduction. If that happens, it may change your strategy.

[Ted_Graham]

Thanks for your comments.

We have enough liquid assets to pay off either mortgage, or both, if needed.

My home mortgage is 100% deductible as well, so why would I keep the rental's mortgage at a higher rate?

[EconoMutt]

If you have enough money to pay off the rental, I'd do that and take the extra cash flow and apply it toward your home.

[jIM_Ohio]

Thanks for your comments.

We have enough liquid assets to pay off either mortgage, or both, if needed.

My home mortgage is 100% deductible as well, so why would I keep the rental's mortgage at a higher rate?

I do not own rentals, but am looking into getting involved with a friend which does own 2-3 rentals (he flips houses and rents them while waiting to sell them, and usually is dealing with 3 units at any given time).

Focus on the ROI of the rental then...

ask yourself this-

how much (of your own money) have you put into the rental. Think about down payment and repair costs.

How much annual profit do you get? That is your ROI (right now).

profit/costs is how I am thinking about that

if you put 20k down and get $2000 profit per year that would be $2000/$20,000=10% ROI
you need to factor in the tax savings into the profit (so if the deductible mortgage interest adds $3000 to tax return, that would be higher than the $2000 profit from just rent alone).

IMO 10% ROI would be a good (GREAT?!?) investment.

If you paid off the mortgage on the rental your equation is the same, but the numbers change.

profit/costs is still the equation

you need to add in what you pay down as a cost
you need to increase the profit because less of the rent payment is going to expenses and more is going to profit. The portion of the tax return which accounted for mortgage interest (as a profit) needs to be removed.

Recalculate.


My friend would generally not "pay down" his rental units, as it would reduce his ROI, and his general philosophy is to have as little of his own money into his properties as possible. This keeps the cost portion of the ROI equation low.

In your case if you pay off the mortgage your costs side is really high, but you should be hoping for the profit to be even higher (as a percentage of costs).

You also need to weigh ROI vs risks- you might have a higher ROI with a mortgage, but you also have more risk (if property is vacant for example) so its a risk-reward tradeoff as well.

Who prepares the tax return for the rental units?

[Ted_Graham]

Who prepares the tax return for the rental units?

I do our taxes with TurboTax, but am likely to get a professional involved this year. We have more investments and more complex investments than in the past.

[jIM_Ohio]

Thanks for your comments.

We have enough liquid assets to pay off either mortgage, or both, if needed.

My home mortgage is 100% deductible as well, so why would I keep the rental's mortgage at a higher rate?

Second comment, which is bigger picture-

each post you make, you are giving a bigger insight as to your big picture...

you have enough liquid cash to pay off 2 mortgages
you have not stated what type of other investments you have, what your risk tolerance is, if you want to keep the rental long term, how much you know about the tax benefits of the rental (like mortgage interest being deducted as a cost and depreciating the rental on tax return).

Depending on what other investments you have, what your retirement plan is, and how much risk you want to take (or what risks you want to avoid), you need to decide what makes most sense with your money. Some of this also changes with age- if you are 35-40 having a rental might be OK, but if you are 60 yo and nearing retirement, it might make more sense to sell rental.

What is your goal with the money? Trying to find best way to pay down debt, trying to have the highest net worth possible, trying to retire as early as possible, or something else?

[jIM_Ohio]

I do our taxes with TurboTax, but am likely to get a professional involved this year. We have more investments and more complex investments than in the past.

Here are tax basics on rentals (not meant to be all inclusive, but meant to open your eyes to issues you are dealing with).

When you file a rental, you use schedule E.
In addition I found this publication which might be of use

http://www.irs.gov/pub/irs-pdf/p946.pdf

The three big things you need to know are

1) income from rental is taxable
2) the mortgage interest you pay is an expense (which reduces the tax paid above)
3) the value of the house is depreciated each year (which reduces the tax paid above)

3a) when you sell the rental you MUST calculate the depreciation and you will be taxed on the difference between the sale price and the depreciation.

If you did not claim the depreciation, you still need to calculate it when you sell the house (its on the schedule and worded very similar to that).


I am not using any tables, or specific examples, but I will make one up.


Let's say you have a 200k house which you rent for $1500/mo and pay a mortgage of $1300/mo (160k financed at 5.5%).

Your rental income is $1500/mo times 12 months=$18,000
your interest paid on the mortgage is $8600 for first year
you calculate the depreciation of the 200k house and the IRS says to take $8,400 depreciation (again this is made up, I did not use an IRS method to calculate the depreciation)

You have 18k of income
you have $8600 and $8,400 of writeoffs against that income. This means you have 17k total of writeoffs.

so you are taxed on 18k-17k=1k (at 25% bracket this is $250 tax owed).
Each year that changes because you have less interest to pay and a different amount to depreciate.

If you pay off the loan, you have no interest expense to use to offset the income- so if you are in a high tax bracket (like 28 or 33%) I might keep the mortgage if it was offsetting most of the income you reported.


Keep in mind above I suggested you use ROI to help decision, and none of above deals with ROI directly...

The ROI on above example would be this

40k cost (160k mortgage on 200k house suggests that 40k was put into property
$1500/mo (rent) minus $1300/mo (expenses) is 200/mo=$2400/year profit
The $8600 mortgage interest is profit as well

so the ROI is
$2400+8600 profit=$11,000/40k costs=27.5% which is really really high (as in really really good).

If the mortgage was paid off that same calculation is now

200k cost (all of property was paid for by you
$1500/mo (rent) is $18k annual profit


so the ROI is
$18,000/200k costs=9% which is high (as in good, but not as good as before).

You need to add in property taxes and taxes owed on rental income as costs to get a better handle on ROI. In general rentals are best if either 100% financed or 100% paid off. Whether you paid off the property or not, the depreciation calculation does not change (to best of my understanding).

[Ted_Graham]

each post you make, you are giving a bigger insight as to your big picture...

What is your goal with the money? Trying to find best way to pay down debt, trying to have the highest net worth possible, trying to retire as early as possible, or something else?

Thanks for taking the time. I'm 36, married with 2 young kids, wife doesn't work, very high income the last couple years, which may or may not continue.

Most of our portfolio is in index funds (in taxable accounts). We're close to having enough to retire and are just trying to make a smart decision about what to do with extra cash.

Rental is worth $350k, with a $180k mortgage @ 5.75%. I've been putting all our money into the market for the last decade and am now wondering about paying off a mortgage to diversify.

[jIM_Ohio]

Thanks for taking the time. I'm 36, married with 2 young kids, wife doesn't work, very high income the last couple years, which may or may not continue.

Most of our portfolio is in index funds (in taxable accounts). We're close to having enough to retire and are just trying to make a smart decision about what to do with extra cash.

Rental is worth $350k, with a $180k mortgage @ 5.75%. I've been putting all our money into the market for the last decade and am now wondering about paying off a mortgage to diversify.

Can I interpret the primary goal as you want to retire "relatively soon" and the rental units are part of that "problem" and "solution" as well as the cash is part of that "problem" and "solution"?

If you think retirement is coming do NOT pay off the properties... what you are doing is moving money from one form (liquid cash) to another form (illiquid house) with a zero change on net worth balance sheet (make sense- if you pay off both houses your net worth does not change, you only reduce your liabilities). In general for retirement you want to keep most assets liquid- if you need to get rid of rental debt, you are best off selling it (I think) and keeping your cash as real cash and not tying it up in a house.


Can I ask how much you have saved for retirement, and what your annual household expenses are (expenses to live on, do not include rentals).

I assume the rental is cash flow positive (meaning it covers all its expenses and gives you a profit)?


Here would be my retirement plan (without numbers)

Make sure the investments are about 20X-30X expenses (if expenses are 50k per year, 20X is $1M invested and 30X is $1.5 M invested). If you have 20X or more without the cash, and more than 20X with the cash, that is a good situation.

Can you express the rental PROFIT as a number and a fraction of annual expenses?

For example if you have 50k of annual expenses, and rental profit (after mortgage, taxes and other bills for rental are paid) is $5k, that means you have 5k of expenses covered and that is 10% of your expenses.


I would then look at how aggressive you want to invest, knowing the rental is kicking in additional income.

Like take 45k out of investments plus 5k profit from rentals for 50k income need; then use the cash to reduce risk (keep it in bank and if something goes wrong, sell the rentals and draw down cash, pay off the rentals and increase income, or something like that).

[jIM_Ohio]

Thanks for taking the time. I'm 36, married with 2 young kids, wife doesn't work, very high income the last couple years, which may or may not continue.

Most of our portfolio is in index funds (in taxable accounts). We're close to having enough to retire and are just trying to make a smart decision about what to do with extra cash.

Rental is worth $350k, with a $180k mortgage @ 5.75%. I've been putting all our money into the market for the last decade and am now wondering about paying off a mortgage to diversify.

I was in a rush when I typed last response, I will let it sit there, but here are some details, after I re-read each post here. I did learn a few new things.

"Close to retire" is probably the key focus. How close? Here is math I would do:

1) Take current annual expenses (make sure things like insurance and car registration are included) and multiply this number by 25. This is your retirement target (you may need more, or could need less than this target, but this target is a good starting point). If you have 60k of annual expenses, 25X 60k is $1.5 M.

2) Add up any investment account balance. Do not include values of either house. If you can leave the cash available "out" (at least enough cash to pay off both mortgages) that might help.

2a) one number is all investment balances (with cash)
2b) one number is all investment balances (leaving out enough cash to pay off both mortgages)
2c) if you have other assets which can be sold, list these here and add them in (for example value of rental if sold, add the sale price into the investment balance)

3) compare the number you have in #1 (retirement target) to what you have in investments now (the various scenarios with #2)

If you have 12X expenses in investments, I would say you are close to financially independent
If you have 25X expenses in investments, you need to do some serious retirement planning (see #4)

4) The planning you need to do:

a) how will your expenses change over next 5-15 years. Think kids college, replacing cars (once every 10-20 years), vacations, travel, health care expenses. Some of these line items were probably not in #1 when you listed expenses, one way to account for this is go back to #1, add them in (as annual expenses) and redo all the math in steps 2 and 3.
b) You need to analyze rental unit as a function of each solution in step 2- I don't know how much you are clearing on the rental (in profit) and if you even want to keep it long term. If its financially beneficial, do you want to be a landlord in retirement? Or would you prefer to sell the rental (and then you could either sell it as a rental, or just sell it).
c) figure out if you want to retire, semi retire, change careers, or do something else (this might be more important than other 3 combined).


Examples (some real, some made up to prove points)

You will have a house paid off in 5 years, this changes expenses in 5 years (lowers them). One reason I had you calculate investment assets without the cash is to account for this "easily". Use cash to pay off the house, and it does not change the 25X target because other monies are being use to pay down the debt.

If all cars you own are paid for, then you need to account for this in budget, some way, some how. One way I like to suggest is if you spend 36k on a new car every 15 years, that is $200/mo you spend on a car over 15 years (36k/(12months*15 years). Add a $200/mo line item to budget for car purchase to account for this.

You need to do similar analysis on spending over a 20 year period- think new roof, new kitchen appliances, home remodeling projects- if you think any of these items will need to be replaced, you need to account for these.

a) one way is reduce spending in one area to pay for the "unexpected" expense
b) one way is to spread the cost of the item over a long period of time (like the car calculation above)
c) one way is to add a slush fund to budget (similar to car) and if you need to replace hot water heater, the 36k car every 15 years is either now a 36k car every 16 years, or a 34k car every 15 years- meaning change a variable on the car to allow you to fix hot water heater.
d) another way is to focus on withdraw rates and lower the withdraw rate from the beginning.


Withdraw rates- this is the initial percentage of investment assets you choose to withdraw. If you use the 25X number, that is a 4% withdraw rate (1/.04=25X). That 4% increases by 3% per year. If your expenses are 60k and investment assets are $1.5 M, 60k is 4% of $1.5M and 60k is taken out the first year. The second year the 60k is increased 3% (60k*3%=$61,800). So the second year the withdraw is $61,800 and that is 4.12% of assets. The 4% only refers to the FIRST withdraw (the first year), not every withdraw made every year.

Because you are 36, I would strongly suggest a lower withdraw rate than 4%/ 25X. Meaning 33X (3%) or 40X (2.5%) would be where I would put expectation. However depending on the rental, (if you keep it) and how well you control spending, 25X MIGHT work. The 25X would not account for rental based on how I did the math above (I can change the math to account for it, but don't want this to be too long).

Here is some history on the 4%. There is an old retirement paper called the trinity study. Scott Burns referred to it a while back and that is how I learned about it. You can google it to learn more.

Basically what some financial people did was back test portfolios (with various asset allocations) and spending and inflation and time periods to come to some very general conclusions (read my signature about specific vs general).

The trinity study concluded that a 60-40 portfolio (60% stocks-40% bonds) would last for any 30 year period in history something like 95-100% of the time if 4% of the assets were initially drawn, and increased 3% per year for inflation.

Read that last paragraph 2-3 times. There are LOTS of "ifs" or assumptions.
60-40 portfolio
30 year time period
4% initial withdraw
3% inflation

That same study did tests on 80-20 and 40-60 portfolios, but concluded 4% was better at 60-40 than say 4.5% at 40-60 or 3.5% at 80-20. (The 4.5% and 3.5% are edits by me, I do not remember the exact percentages of those portfolios).

So you have 2 things which are moving beyond the scope of the study-
1) is 30 year time period- this factor alone impacts your solution more than any other. (you will need your assets to last 60 years, not 30)
2) No idea if 60-40 is right portfolio for you (it might be, I am just pointing this out).

Since that study, there have been other tests for 40 years, and one I pay close attention to suggested that at a 3.3% withdraw rate, the asset allocation no longer matters (25% equity had same results as 50% equity as 75% equity as 100% equity over 40 year periods with a 3.5% withdraw rate). It might have been 3.3%... I would need to dig it out and re-read it.

My point was to focus on withdraw rate with any analysis you do, or a financial planner does for you. If you meet with a planner after they present something to you, ask them about the withdraw rates and portfolio survivability rates.

If you look into this and withdraw rate is 5% or higher, my advice would be go back and save more money or get a second opinion from a different planner.
If you look into this and withdraw rate is 4% plus or minus a half percent (3.5% to 4.5%) you are really close and it's probably easier to cut expenses in this case. Any planner which suggests this is reading same things I am.
If you look into this and withdraw rate is 3.3% or lower, you have nearly a 100% chance of portfolio lasting your whole life and being there for kids too. Good planner as well.

I realize this is a lot to digest, I hope this helps.

There are still many many details to follow

1) withdraw strategy
2) expenses strategy
3) portfolio volatility strategy

meaning for a long (60 year retirement) having a basic plan to account for unplanned, but planable events (is that a word??). For example if portfolio loses 40% in one year, you need a plan for that, if expenses spike early in retirement because of health problems, have a plan for that, if you have money in 401ks, Roths and taxable accounts, you need to figure out which of those to take out first.

[Ted_Graham]

Thanks for the detailed posts.

3.5-4% withdrawal rates are in line with other suggestions I have read (e.g., The Four Pillars of Investing, which I highly recommend).

I don't know our annual expenses, I can guess, but probably not better than 20% accuracy. But I'm fairly confident we are at 25x right now, and I'm not planning on quiting my job; it is challenging and enjoyable.

I'm trying to decide how paying off the rental mortgage (30 years @ 5.75%) compares to paying off our house (5 years @ 3.5%). It sounds like the tax advantages of having a mortgage on the rental exist, but are not hugely significant. So if I pay down a loan, it will be the rental.

That said, now I have to decide between paying down the rental's loan and making an aggressive real estate investment that could return 12-20%, but has risk of loss (the investment I'm considering is a commercial deal, where I would just be a passive investor). I realize that isn't enough information for you to help, just letting you know my thoughts.

[jIM_Ohio]

Thanks for the detailed posts.

3.5-4% withdrawal rates are in line with other suggestions I have read (e.g., The Four Pillars of Investing, which I highly recommend).

I don't know our annual expenses, I can guess, but probably not better than 20% accuracy. But I'm fairly confident we are at 25x right now, and I'm not planning on quiting my job; it is challenging and enjoyable.

I'm trying to decide how paying off the rental mortgage (30 years @ 5.75%) compares to paying off our house (5 years @ 3.5%). It sounds like the tax advantages of having a mortgage on the rental exist, but are not hugely significant. So if I pay down a loan, it will be the rental.

That said, now I have to decide between paying down the rental's loan and making an aggressive real estate investment that could return 12-20%, but has risk of loss (the investment I'm considering is a commercial deal, where I would just be a passive investor). I realize that isn't enough information for you to help, just letting you know my thoughts.

Curious how you think the tax benefits of the mortgage on the rental are negligible?

I would also get a better handle on current expenses
with so much cash on hand, I would think putting some of that cash into the commercial real estate would be good to diversify investments.

One reason I comment on diversification is that because you have 25X expenses (or close to it) now, your best planning mechanism is to tie money up in uncorrelated assets to PRESERVE the wealth you have.

For example, if you have 25X now, and have 50X in 9 years you might say GREAT, but if that same 25X became 12X in years, you might feel trapped- negative returns on whole portfolio could really dampen your outlook or reduce your choices.

[Ted_Graham]

Curious how you think the tax benefits of the mortgage on the rental are negligible?

I would also get a better handle on current expenses
with so much cash on hand, I would think putting some of that cash into the commercial real estate would be good to diversify investments.

One reason I comment on diversification is that because you have 25X expenses (or close to it) now, your best planning mechanism is to tie money up in uncorrelated assets to PRESERVE the wealth you have.

For example, if you have 25X now, and have 50X in 9 years you might say GREAT, but if that same 25X became 12X in years, you might feel trapped- negative returns on whole portfolio could really dampen your outlook or reduce your choices.

Sorry, I should have phrased that as the tax benefits of having the mortgage on a rental are not that much more significant than the tax benefits of having the mortgage on my primary residence.

I agree with the uncorrelated assets; that is why I'm finding the commercial real estate deal attractive. I have a good size REIT position, but this is a higher risk/reward deal.