Should I pay off rental when I refi my home? Tax implications?

Question

We have an opportunity to refinance our home and cash out enough to pay off one of our rentals. By doing this we will lower our monthly payment by 450/mo OR if we make the same payments we can reduce our total cost over the life of the loan by 55k and pay it off 9 years earlier.
We won't have the interest to deduct on Schedule E for this house, even though we will be able to deduct if on our personal schedule.

Will the increased profit on the LLC outweigh the increased deduction on the personal side? Or do they tend to wash out?
Or should I even care since I have the potential to pay it off 9 y and 55k earlier?
Obviously, my qualified tax professional would provide the best input here, but I am hoping to get some quick input before I shell out her hourly fee.
Thanks for any input!

Bill Gulley · Answer

Hi, In short, it is not a wash as the increased income to the business has an opportunity to be reduced by other expenses which are not available under your personal deduction. The opportunity cost of financing should be assessed not only on an after tax basis but primarily on the use of funds and economic alternatives available to you. What is your cost of money on the rental, is that the best use of funds? What about acquiring other properties and increasing cash flow, providing additional income? With current rates providing new financing could you then reduce higher rate obligations from newly generated income even faster? If leveraging yourself into other ventures is not a viable option or in your business plan, reducing existing debt is always a good idea. Tax consequences alone will probably not justify re-financing, the question should be, whats the best use of funds made available? Good Luck, Bill

Steve Babiak · Answer

Mortgage interest deduction for personal residence phases out with increases in income at a certain threshold (depends on single or married status). Mortgage interest on a rental can ALWAYS be deducted from the rental income on a rental. To not lose any mortgage interest deductions, my CPA wants me to start looking at paying off the house where I live, by taking refi money from the rental property! As to whether you will really have better cash flow ... It is said that any property can have positive cash flow as a rental when it is paid off in full - that is a given. So that bigger mortgage on your personal residence will be paid by you taking income from another source (say your 9-5 job). Effectively, this means that you have that other income subsidizing your rental so that the rental looks better as a rental. I just don't like the idea of me working extra to make the rental a more affordable thing for a tenant by subsidizing that rental with my other income source(s). As to the 1031 exchange: if you were to have a HELOC on your personal residence, you could use that to instantly pay off the mortgage balance if needed to facilitate a 1031 exchange; so you can defer the full payoff until you are in a 1031 exchange scenario. The best advice that I've read in the other posts in this thread was to use your CPA for tax PLANNING, not just tax preparation. And then the suggestion that your funds might do better by being invested in more properties. I would suggest the following: have mortgages on the rental properties to the extent where they still cash flow positive (do not over-leverage into negative cash flow); have your personal residence paid off, AND have a big HELOC on that personal residence for emergencies or for investing further. Some even consider that big HELOC as a form of asset protection, since the equity in that property appears to be less than the value of the paid off property (supposedly to keep the lawyers from pursuing lawsuits against you with the property as the target to get paid out of).

Rich Weese · Answer

THE END IS NEAR!!!!!!!!. I find myself agreeing 100% with the Zivmaster. That is scary. Great points , Eddie. The only thing missing is to determine what the goals and strategy is of S Harper is. That would also make a difference. Age? Your funds may do more you by investing in other properties. Rich

Eddie Ziv · Answer

From a tax perspective, your accountant would be the best to answer, however from RE view it depends: 1. What is your financial situation and how that monthly saving impact your bottom line. 2. How good the property is (Appreciation potential) and quality of the neighbourhood 3. The term of the loan 4. Can this money be used better if invested somewhere else. In the heyday of the real estate boom, people believed that they can do no wrong and appreciation would outweigh any mortgage product. We all know the outcome. If your loan have a low fixed rate and financially you are capable of holding it, one can argue that giving the financial forecast of high inflation, it would make sense to keep that loan since eventually it will be eroded by the inflation.

Account Closed · Answer

I think it depends upon how good the rental is and how long you want to keep it. If you are happy with the house and it is not located in an area that is likely to go bad, then, yes, pay it off. It's nice to have the presure removed of the need to get that mortgage paid whether there is a renter or not. Income from the house will be good without the mortgage to pay. If the house is a good one, it will be suitable for retirement income. 1031 is easier to do on a free and clear if you ever want to sell it. You eliminate the need for an equal or greater mortgage on the new property. No risk of mortgages being so tight that you can't get one and thus can't do a 1031.

Eddie Ziv · Answer

Don't buy al the real estate there. Keep some for the Chinese... :wink:

Eddie Ziv · Answer

That's funny, Rich. I showed it to my wife and she was on the floor. I knew your are rich and opinionated but I didn't know you have such good sense of humour. I'll give you a vote for that one. :clap:

Rich Weese · Answer

Thanks Eddie. I've been told I have a great sense of humor, just not in politics. I find nothing humorous there. Rich, heading to Hong Kong today.

Niman S. · Answer

I am going through the same exact process myself. Luckily I can offset the extra income on the paid off rental using my other rentals - so pretty much a no brainer for me. The paid of rental is in a good neighborhood, good for long term, and will probably be great for a 1031.

Jim Wineinger · Answer

In order to compute what you want to you must know IN DETAIL all the income and expenses of BOTH your personal income and your LLC income. Your personal interest is deductable, but only if it exceeds a certain percentage of your gross income. So your savings here is related to that percentage of savings divided into your personal tax rate. Which has to be compared to the same increase (by not having the expenses in the LLC) times the LLC tax rate. Some will argue that these figures are a virtual washout, but without them actually being computed (or at least estimated) by the one who knows them best (you and or your CPA) you will never know the answer here. I have done this AFTER the fact for people to show them which way would have been best and have seen the answer to be both ways depending upon the situation and the savings is usually a very good amount compared to the other way. It is rarely a washout. It is usually enough to pay for that trip to the "good CPA" who specializes in tax planning, not tax preparation.