All Forum Posts by: Spencer Brennon

The interest deduction is best avoided by paying off the loans early. Each $1000 you spend in interest only earns you at maximum $396 in tax savings...so the author would still be donating $604 each year to the Wichita Bank Shareholders Fund. By paying off the loans early, the author will be retaining that $604 to purchase additional homes, make repairs, or take a vacation to Fiji. (OP indicated this was for retirement planning.) Encouraging the author to continue paying interest in order to capture only a small percentage of it in tax savings (when there are so many other tax shelters for real estate investors, especially with regard to retirement) isn't fair. There are far more efficient ways of lowering a tax bill than sending money off to Wichita Bank shareholders.

To the author--

I think with regard to liquidity, you should carefully examine what your needs are. If you expect to require no major sources of cash in the next ten years, I say pay off the homes in the fashion described, as long as you're familiar with the sacrifice in returns you get by not continuing your leverage. I do recommend having HELOCs and significant pooled cash reserves to protect against the unforeseen--be that a credit crisis, higher vacancies than you expected, or any other form of "uh oh". Once you have paid off the homes, the excess net cash flow should be enough to self-finance each property's "uh oh" fund and give you access to some of the cash reserves for expansion of your portfolio. If, however, you expect to expand your portfolio quickly or become a private lender, access to capital is far more important, and I would encourage you to pay off the properties according to the mortgage schedules. 

Overall, I think this type of strategy is great for a conservative investor who wishes to build net worth by a defined amount very quickly. Epictetus, the ancient Greek philosopher, noted that grounded optimism often leads to the greatest satisfaction in life. By mitigating risks and securing a reasonable growth plan, I think you're setting yourself up for that satisfaction during your retirement. But Epictetus also taught that we must be willing to change the rules and our strategy to fit our circumstances -- if you're not the type of conservative investor this strategy suits (as I imagine Mr. Bowling above is not), then don't use this strategy. If you want to build your gross worth very quickly and slowly pay down the debt as you near retirement, this is not for you. If you want to have access to capital in case another 2008 occurs, this is not for you. The beauty of this strategy, however, is that it is malleable -- as long as you are open to realizing changing conditions, you can stop expedited paydown any time and start using that cash to expand your portfolio, take a vacation, or invest in something else (for diversification). The important thing is ensuring you are capable (financially and mentally) of making the decision to alter the strategy amid changing conditions.

Devise something that suits your personal investment objectives, risk profile, and lifestyle and along the timeframe that you need.

 Hi, Joe. The difference between credits and deductions confuses a lot of people, and we see the terms interchangd a lot. (I cringe when I hear about the "mortgage interest tax credit".) I've put an IRS link at the bottom for their official explanation, because they felt they even had to put out a special bulletin explaining the difference. So many people confuse them even the under-staffed IRS spent time trying to clear it up. 

• A Tax Credit is a dollar-for-dollar decrease in the amount you owe on your taxes, ie your tax liability.

If you owed $5,000 to the IRS next April 15 but you had a $2,000 tax credit (for a solar panel, for example) you would only have to write the IRS a check for $3,000. 

• A Tax Deduction is a dollar-for-dollar decrease in the amount on which you are being taxed, ie your taxable income.

If you owed $5,000 to the IRS next April 15 but you had a $2,000 tax deduction (for mortgage interest, for example) you would only have to write the IRS a check for $4,300 (assuming a 35% tax rate). 

A tax credit is always more valuable than a tax deduction, because a credit saves you 100% of its face value but a deduction saves you only a percentage of the deducted amount. Spending a dollar to get a tax deduction is silly, unless there's extraneous value for the spend. Like I quoted above, you end up spending $10,000 to save $2,500...with nothing to show in the end, if we're speaking about a mortgage interest deduction.

http://www.irs.com/articles/tax-credits-vs-tax-ded...

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@Jessica On the subject at hand, I would question the reliability of cash flows that hinge on the financing. If the figures are small enough that a slightly different mortgage payment makes or breaks the investment, I'd say you might need to move on. If it's a tough area or I'm misunderstanding, though, then I always encourage a 30 year mortgage with a personal goal of repayment within 15 years. That way you're not tied to the 15 year timeframe (if you need the cash for something else, for example) but you also aren't living under the spectre of endless debt. You will pay a slight premium in interest, but I think the optionality is worth it in most cases. 

I personally love robin egg blue, but unless you're completely replacing the roof, I'd pick something in the maroon/red family to match the shingles. 

 Don't make it a dichotomy where it's either wealth or cash flow as if they're not related. The cash flow you generate builds your net worth up in the same way, regardless of the capital structure. Leverage merely compounds the effects, better and worse.

For example, Bob Safe hates leverage and purchases rentals with all cash. He generates $1,000 a month in cash flow. His net worth is therefore increasing by $1,000 a month (assuming he plows all of that into the next single property). Susie Risk, however, loves leverage and only pays 20% on her rentals. She generates $1,000 a month in cash flow before the mortgage for each property. 

The net worth impact from a rental is calculated by taking the value of the underlying asset (a home worth, say, $500,000) and subtracting the liabilities held against the asset (ignoring retained earnings). Leverage has no material immediate impact on net worth ceteris paribus, because Bob Safe has one $500,000 home contributing $500,000 to his net worth. His total outlay is $500,000. Susie Risk paid $500,000 for a 20% stake in five $500,000 houses, leaving her with a total net worth of $500,000. The difference is that she is receiving a cash flow from the properties that she will plow into additional houses, just like Bob Safe, but she also has a mortgage payment before cash flow that is enhancing her net worth through principal paydown. So even if Susie Risk has a slightly negative cash flow, she can be increasing her net worth at a faster rate than Bob Safe.

The problem is that a change in real estate prices will impact Susie five times as much as Bob. Houses appreciate 10%, Bob makes $50,000 and Susie makes $250,000. Houses depreciate by 10%, Bob loses $50,000 and Susie loses $250,000. At the end of the day, this has very limited impact as long as Susie has planned ahead. If she is relying on a HELOC to fund a new roof in a few years or on credit liquidity to facilitate any uh-ohs in the near-term, even a tiny decrease in property values will be devastating to her. (Corporations had huge problems with this in 2008.) BUT - if Susie maintains liquidity in the form of emergency reserve cash, untapped credit revolvers (through HELOCs taken out at the $500,000 notional value of the property, before the change in prices), or some other way of paying for the new roof or the uh-oh without additional or new financing, then she won't have to worry about property prices until she sells, which in the land of Warren Buffett is never.

This is why on this site, I always question those who say they ignore appreciation in determining their models for financing a deal. My general method is to assume (in the beginning) a sudden and drastic depreciation in order to stress test the financials and make sure the risks are managed properly to my risk appetite, which is quite hedged. Others will be happy (as I'm sure you noticed in your profession) to overconsume risk and, as the old economists would say, laissez faire ("let be what would be") with the downside possibilities.