Paying off mortgage quickly vs cash flow for salaried people ?

Question

Hello,

While majority of the people on BP are always championing cash flow, I beg to differ the strategy while thinking long term. I am curious on what other people think of it.

Currently I am taxed at 35% of my income, so if I generate 10% CoC, I am basically getting only 6.5% in my pocket. My current work is very flexible with plenty of time at my discretion. I don't intend to leave it in near future mostly for my passion rather than financial reason. I however realized that it doesn't make sense to have 30 years AMT if I am thinking long term despite having low borrowing cost. Here are the 2 options

#1

- Payoff mortgage quickly by targeting 8-10 years AMT. I will have to pay lower taxes on my other incomes as well since I am servicing a debt. I can possibly pay a property 8-10 years very easily and possibly even 5 years. Once I fully pay the property, I can refinance it to buy another property and only aim for cash flow when I decide to fully retire. If I have multiple properties, I will aim for paying off the one that I can fastest.

#2

- Aim for maximum cash flow with 30 year AMT.

Cashflow is great, but I will be giving away 35% in taxes and I don't see lot of use of cash since I live modestly in comparison to earnings. I can't even invest that 6.5% since it's too minor, but with refinance I don't have to pay taxes.

I am curious on your thoughts in favor of #2 as opposed to #1 in my case.Thanks

Kevin Siedlecki · Answer

@Haseeb Awan

Good thought, but there are two major misunderstandings in your analysis.

First, and most importantly, when you pay the loan down early, you are paying principal. That principal is taxable, so you aren't changing your taxable income at all. By paying early, you are actually giving yourself a higher tax burden sooner, because when it's paid off, you'll have even more cash flow to pay taxes on. That's where your plan makes more sense - to refi and buy. But the premise you start with, that you won't pay taxes on it if it goes to the mortgage, is incorrect. There's no difference in that income whether you turn it into equity in the house or put it in a savings account.

Second, more complicated but also important to note: You are ignoring depreciation in your tax equation. That makes a big difference. If you are leveraged at 75% LTV and making 10% COC, you're getting the first 7.5% tax-free. Here's a quick example, but it works at any price point. The only caveat is that as you pay down more principal, you get taxed on that, as I explained before, so you are taxed on more than just the 2.5% left over, and as the principal portion of the payment goes up, you pay tax on even more.

$100,000 purchase price

Down payment $25,000

10% COC ROI = $2,500

Assessed value: Land 20,000 (25%), Improvements 60,000 (75%)

Depreciation deduction: 2.5% of 75% of purchase price = $1875 (7.5% of the 25k acquisition).

This might merit a longer explanation, including how the principal affects the numbers, but that's basically how it works.

Kevin Siedlecki · Answer

@Haseeb Awan - You are absolutely right about how income works, but principal payment counts as income. Every expense is tax-deductible, including the interest on the loan, but because "money isn't real," it doesn't matter if it's equity in property or cash, it's considered income, and it's taxable.

Mike Warder · Answer

Putting aside the varying time horizons and risk threshholds we all have, I think you should lock in the current mortgage rates on fixed 30 year loans and hire a real estate-savvy CPA to work on your tax concerns. Seems like paying off one property, as you suggest in option #1, to eventually refinance it to buy another property is just chasing your tail. I too have a full-time job that I'm not leaving. It is because I'm staying in my current job that i'm okay with leveraging myself with multiple financed properties. Every once in a while I think about paying down my debt, but since I have a good steady income, I realize there is not much benefit numbers-wise to doing that. But, do whatever helps you sleep at night!

Kevin Siedlecki · Answer

@Haseeb Awan - you're basically correct, but Account Closed's way of looking at it is more complete, and mortgage principal is not a valid deduction.

The principal you pay isn't technically an expense. One way to look at it is as a transfer from cash to equity in real estate. So you are still responsible for paying taxes on that portion of your mortgage payment, because it adds to your wealth.

That's the third different way I've tried to explain it - so if it still doesn't make sense, you'll just have to trust me on it. Anyone else care to try to explain it more clearly?

Haseeb Awan · Answer

@Kevin Siedlecki

Yes, but you pay tax on your income after paying off mortgage not before that . Isnot?

Account Closed

Unfortunately, I will qualify for both income brackets since I have real estate in both countries and also permanent residency. I however don't live in US. My advice was more generic .

If you pay off your mortgage early and don't generate cashflow, you won't pay any tax because of 0 income from property. Am I missing something here ? In short term, you wont have any cash flow but in long term its beneficial

Account Closed · Answer

Income tax in the US is based on cashflow less deductions. You can owe no tax because there is no income, or owe no tax because valid deductions are such that the net is not taxable. I would say that it is accurate to state "if you don't generate cashflow, you won't pay any tax" because of no taxable income. Has nothing to do with whether the mortgage is paid off. If you have cash flow, and deductions, you can still end up in a no tax situation. If you have mortgage payments to make but no cash flow, then taxation is not your biggest concern.

I think we are saying the same thing here.

Account Closed · Answer

@Haseeb Awan, I notice that you are from Ottawa. I am originally from BC. Canada and the US are not the same on this issue. Also, the US treatment of income for non-US citizens differs from US citizens. I am curious, for your question, whether you are looking for Canadian advice, US for US citizen advice, or US for non-US Citizen advice.

Travis Hughes · Answer

Agreed with most of the previous posts here.  If the goal is to continue purchasing more real estate, then you don't want to sink all of your capital into one property to pay down the debt on it, just to cash out refinance.  Get your properties leveraged at a rate that is acceptable to you up front, then make the standard payments each month and take your other capital over to a new property.  Having a mortgage is generally good in terms of taxes (in the USA) and cashflow.

That having been said, the exception here might be if you are highly debt averse.  Every investor has to make their own decisions as to what levels of leverage that are willing to take on.  I think most people would agree that if you purchase all-cash or only hold one mortgage at a time and pay it off before moving on to another mortgage, your overall returns will be reduced because of a slower velocity of money.  As @Mike Warder said, if that's what helps you sleep at night, by all means please do so.  No one can tell you that it is the "wrong" way to invest.

Haseeb Awan · Answer

@Larry Smet - Thanks a lot for the response & I liked it when you used the word empire !

Larry Smet · Answer

Hi @Haseeb Awan

The simplest way to look at it is only the interest portion of your mortgage payment is deductible (is an expense that you can claim).  As you pay down the mortgage your annual interest expense will gradually decrease as more and more of each mortgage payment goes toward principal.  Of course, you can always refinance down the road to boost your expenses and take out tax-free equity which you can use towards growing your real estate empire.  :)

Paying off mortgage quickly vs cash flow for salaried people ?

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