Tax Implications; Cash Flow or Amortization

[Peter W.]

I've never invested in investment rental properties and I have a question.  I am buying a small multifamily unit for $1.535mm and will put down 30% and borrow 70%.

If I finance purchase with a 15yr fixed my monthly payment will be $8000 which includes $4500 principal reduction; my yearly NOI will be $96,000 so my cashflows are breakeven.

If I finance purchase with a 30yr fixed my monthly payment is $5132 which includes $1555 principal reduction; my yearly NOI is still $96,000, but my free cashflow goes from breakeven to $34,416.

The $34,416 becomes taxable (pre-benefits like depreciation) while there is no taxable income with the 15yr mortgage. Would it not be best for me to finance with 15yr?

Thank you in advance for your advice.

[Andy D.]

I'm not a CPA but have been doing this myself for quite some time until I got myself a CPA just to be on the safe side. CPA so far has to yet correct anything that I'm doing/preparing so I think I'm doing it right. ;-)

Anyway, why don't you take a look at Schedule E (to from 1040) to derive at the answer to your questions: https://www.irs.gov/pub/irs-pdf/f1040se.pdf

Starting with line 3 you will see all the relevant parts that are to be considered when figuring out your taxable income (emphasis on "taxable" as this is ultimately what counts with respect to this particular discussion here).

The form is fairly straight forward IMO. It also makes it rather obvious that the higher e.g. line 12 is, the smaller an amount will remain on line 21 (the same, obviously, goes for the other lines 5-18). As this amount is transferred into line 24 it ultimately ends up in line 26 which then is copied over to line 17 of form 1040 --> taxable income from real estate investments (to keep it simple; Schedule E is for some other forms of income as well).

Having said that: with a 15 yr mortgage vs a 30 yr mortgage your monthly mortgage payment for the 15 yr one will contain much more going towards the principal than with a 30 yr mortgage (you have only half the time to pay it off!). I'm not saying that the principal percentage will be higher than the interest percentage (in relation to these two figures); that depends on the details of the loan and is not the point here. The point is: you are paying much more every month without really increasing the amount for line 12 of Schedule E (heck, you might actually decrease the interest portion that way). The details should be very, very obvious when looking at the part of the payment for both types of mortgages.

And when you look at Schedule E you will nowhere find a line where you could enter the principal amount (and no, it does not go on line 19 ;-) ). Getting or paying off a loan (not talking about the interest!) is not tax relevant.

Finally, when calculating NOI one does not consider debt service. The latter has nothing to do with your income situation related to the property. Details of the debt would only be considered/become relevant for e.g. cash-on-cash return or, and here it goes again: for your taxable income (see above).

Maybe this answered your questions (and possibly misunderstanding of NOI). You may want to do a search here on BP for the explanations of NOI, COC, IRR etc.

In any case, good luck with your first investment!