Don’t Pay off Mortgage for tax breaks?

[Ibrahim Yamini]

My Uncle used to flip houses and he was very successful at it so I usually take his advice seriously.  However, he said something to me recently, that just didn’t make sense.  He told me that I should never pay off my mortgage because it helps with taxes if you don’t fully own your home.

Mathematically this made no sense.  With principle and interest I pay over $18K a year on my mortgage.  I find it hard to believe that the government is going to charge me $18K a year just for owning my property or give me tax breaks that will supplement that.  What the heck is he talking about?   is it ever bad to fully own your property outright?

[Ben Zimmerman]

All expenses for rental properties are tax deductible. Items like interest paid, property taxes, insurance, property management, HOA fees, etc etc. About the only thing that isn't deductible is your actual principle contributions.

To keep math simple lets assume you pay 4k in mortgage interest on your rental property for the year and you are in the 25% tax bracket.  Because your interest is tax deductible, you can claim that 4k in expenses and the IRS will refund you 25% of that, and give you 1k back when you file your taxes.  Now obviously paying 4k to get 1k back doesn't make sense on its own, but lets think of things another way.  If your mortgage interest rate is 4%, then because you are getting a refund from the IRS for 25%, that puts your 'effective' interest rate at only 3%.  At 3% effective rate, that loan is barely keeping pace with inflation in terms of relative purchasing power.  So in terms of pure purchasing power, its relatively close to a free loan.

These benefits get larger the higher up in the tax brackets you are.  Imagine being in the 37% federal bracket and living in CA paying an extra 13.3% state tax.  So your effective tax rate is over 50%, which turns a 4% loan into something closer to a 2% loan due to the tax breaks you will get.

Or think of it another way.  If you were investing money in the stock market, or any other form of investment, would you be happy with a 3% annual rate of return?  -Probably not.  But that is effectively what you are getting by paying down your 4% interest mortgage in the 25% tax bracket.  Instead of paying down a very low rate mortgage, why not use that money to buy a second, or third rental property and create a snowball effect?  If you have 100k in cash, then you can either buy 1 home worth 100k, or buy 5 properties each with a 20% down payment (omitting closing costs for simplicity sake).  Now instead of 1 house going up in value over time due to appreciation, you now have 5 houses each going up in value.

Leverage is one of the things that makes real estate so immensely powerful.  Without leverage you are probably better off just investing passively in the stock market.  If a 100k home appreciates by 3% per year, then a fully paid off property will go up in value by 3k and achieve a 3% rate of return on your 100k of cash.  However if that same home was financed with a 20% down payment, then the home still went up by $3,000 but in this case you only needed to spend 20k to get that 3k appreciation, so your rate of return is 15% as your equity jumps from 20k up to 23k.  

It's never 'bad' to fully own a property outright, its just a matter of goals.  Owning a fully paid for home is ultra safe and low risk, however with that low risk also comes lower financial rewards.  Leveraging a property that is cash flowing is only marginally riskier, but generates significantly better returns.

EDITED:  I see that you clarified that it was your house and not an investment property, in which case there isn't much that is tax deductible for you.  However the general point remains, why pay down a 4% mortgage when a simple stock market index fund will likely generate ~10% annually over the long run?  As long as you are financially stable and can weather the storm in a down market, then investing in additional assets will far outperform paying down low interest rate mortgages.