Mortgage Advice

I need some Tax Advice for rental property. My primary residence is in Va. I paid off my home last month and it is valued at about 250k. I also own a rental and it is valued at about 140k. I currently owe 4500 on it and it will be paid off next August. I am thinking about buying a second rental for 170k. I am not sure the best option for financing it. My credit is excellent. Here are my options: Option A: I can finance 80% of the 2nd rental (135k) @ 6.3%. I can then do a cash-out refinance of my first rental property for 35k at 6.3%. The positive side of this is that come tax time, I can take the standard deduction since I own my primary residence free and clear. I can also deduct all my mortgage interest paid on my "Schedule E" thus I am writing off interest against my rents received. Another positive is that my home has nothing against it thus it is somewhat safe in case of a major catastrophe. The negative side of this is that I would be doing two closings since I am using two properties to come up with the 170k and the interest rate is 1/2 point higher since it is investment property. Option B is for me to take out a mortgage for 170k from my primary residence. The positive side of this is that I can get the loan at 5.8% instead of 6.3 because it is my primary residence and not an investment residence. I would then own two rental properties free and clear. The negative side would be that there are no interest that can be deducted from the rents received on the "Schedule E" I would have to itemize and I could only write of the interest against my primary residence, thus the Standard Deduction would no longer be available to me. Another con is that I now owe money against my primary residence and in case of a catastrophe, I could loose my home. My yearly income from wages would be about 50k not counting rental income My first rental would rent for about 800 per month My second rental would rent for about 1200 per month. Please provide any additional insight that I may be missing. Also, please advise any tax issues if known and recommend weather you think I should go with Option A or Option B. Thanks Pat

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Reply to
komobu
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For the numbers you are talking, the difference may depend on the missing details, such as what other Sch A deductions would you have? Property Tax, State tax, etc. You say with no morgage on your home, you wouldn't itemize. But do you 'just' miss it? How much would the two closings cost you? I'd offer an Option C: Finance the new rental on its own for the 80%, but arrange for a home equity line to fund the 20%. You then could use the extra rent to agressively pay off that equity loan, and still have it available for the next deal. You should be able to find a no-cost HELOC to take care of this. I understand the good feeling a home with no mortgage would bring, but I'm not so sure you are as protected as you think. You are still liable for the two rentals, unless you've considered puting them into an LLC. Good luck, JOE

Reply to
joetaxpayer

komobu wrote:

You have a fundamental misunderstanding of the "Tracing Rules" for mortgage interest. If it's any consolation, I have yet to meet a civilian (non tax pro) who understood them - Sadly, I've met far too many tax pros who either don't understand them either or fail to apply them. The Mortgage Interest Tracing Rules REQUIRE you to trace the usage of the mortgage money and report the interest expense on the most appropriate form. So in in either of your examples you need to allocate the interest between the two rentals and claim the mortgage interest on the appropriate Schedule E. In your option A, even though you have two properties mortgaged, the interst on the $170K goes on Property B and the interest on the remaining $4,500 from property A stays on property A - EVEN though you've mortgage property A to buy property B. In your option B the mortgage interest would get reported on Schedule E for property B. Otherwise, you'd be limited to deducting the interest on NO MORE than $100K - this is the deductibility limit on home equity loans. Since you have no mortgage on your home if you borrow $170K you can only deduct the interest on the first $100K on Schedule A anyway. Compound this with the Alternative Minimum Tax Requirement that you add back the Home Equity Interest when you recalculate your AMT and you'll find that you get very little benefit from putting the mortgage interest on your Schedule A. BUT since we are required to trace the use of the funds and the funds were used to buy a rental ALL of the interest can go on Schedule E so don't have a deduction limitation and you will likely avoid the AMT trap altogether. Whether you use Option A or B is a decision that is not just a financial one. You don't give us enough information to make a real tax recommendation, that would take a lot more info - your age, marital status, state, tax bracket, etc. However, I agree that not having your home encumbered is a big (NONFINANCIAL) plus - I like this. This is a vote for Option A. But considering you'll get an above the line tax benefit either way, paying less is always better than paying more. So this is a vote for Option B. I would recommend you consult with a local tax pro with real estate experience AND a local real estate attorney in your locality and see about: Setting up LLCs to hold the rentals - this could help limit your personal liability; Using Option B to loan the money to the LLCs that hold the property - you may be able to encumber them with a mortage from YOU!, but you really need legal guidance on this. I do NOT know if this will work. Good luck, Gene E. Utterback, EA, RFC, ABA

Reply to
eagent

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Well, the best answer to this question is to compute the taxes both ways and compare. BTW, you didn't indicate what your filing status is, which has some bearing on the answer, but here's some quick calculations. The 170k loan will have interest of about $9,800 (5.8%) or $10,700 (6.3%). So that is roughly the amount of the standard deduction for MFJ, which means that you wouldn't get any direct benefit from itemizing (although it would make other itemizable deductions such as state income tax, property tax, etc. worth itemizing). So, if you don't have any other significant itemized deductions, you may be better off tax-wise to use the rental properties for the mortgage, especially since the difference in interest is only about $900/year and dropping each year. So the question then becomes, will you save at least $900 in taxes the first year? Hmmm, with $50K income and the potential depreciation, you might not actually save that much given that the rental write-offs could easily reduce your income tax to zero. That really goes back to the first point, namely that you would need to do at least a rough calculation of your taxes under both scenarios. And there is, as you mention, the peace of mind issue. How much is that worth to you?

Reply to
Tom Russ

komobu wrote:

Deductibility of interest is determined by tracing what you are using the proceeds for. With Option A, the interest on both loans would be deductible against expenses on the new

170k property, because this money was used to acquire the new rental. With option B, because you are using your home as collateral for the loan, the interest can be deducted either on Schedule E of the new rental you are acquiring or split between Sch. A and Sch. E. If you choose to deduct some of the interest on Schedule A, only the interest on the first $100,000 can be deducted. This is because the money is not being used to acquire a personal residence or add on to a current residence, so it is considered a home equity loan, which is limited to $100,000. The remainder of the interest can be deducted as an expense on Sch. E for the new rental. One reason for doing this might be to reduce the loss on a rental. Passive losses are limited to $25,000/ year on rentals for most taxpayers, so if your loss is greater than this, you can deduct some of the interest payments on Sch. A rather than have to carry the passive loss forward. Of course, this depends on what other deductions you might have for Sch. A. However, once you choose a method of how to deduct the interest (Sch. A vs. Sch. E, or both) you must continue that method for the life of the loan. In terms of losing your home, if you have a catastrophe, you could try to sell one of the rentals to pay off the loan, or take out a loan on one of the rentals to pay off the loan on your home. If you end up in bankruptcy, your primary residence is usually exempt from being taken. Dennis
Reply to
bono9763

Tax considerations aside, this doesn't seem like a very good investment to me. $1200/month * 12 months = $14400

$14400/$170000 * 100 = 8.5% gross return on your investment.

The mortgage is going to cost you around 6%, so now you are down to a 2.5% return. Subtract property taxes, insurance, maintenance, and possibly utilities, and I bet you are left with a negative return. And, this assumes a 100% occupancy rate.

So, this investment will likely only break even or cost you money out of pocket every month on a cash flow basis, with your only real return being the tax deduction from the depreciation. At your incremental rate, even this isn't worth that much. Unless you have strong reason to believe that the property will appreciate in value substantially (which in the current housing market seems unlikely), I'm wondering why you want to do this deal. The numbers don't work.

Reply to
way111

Likely, the OP understands his area, the rental market, etc. Given his ability to own his home outright, and have a rental fully paid for, the breakeven doesn't look bad. Look at it this way, he will have two units, which, combined, give him positive cash flow. The 'negative' result of this purchase would keep his income from the first from being taxable. Any gain in value or increase in rent is profit to him. Think about this, had he not aggressively paid off his home and the first property, and saved that money, he could put a downpayment of 30%+ and have the property he's buying look like a positive flow from the beginning. (disclosure - I owned 4 rentals, had bad experiences, and now have just one. I made all the mistakes the OP seems to be avoiding, overleveraged, bad tenants, etc. I was young and stupid) JOE

Reply to
joetaxpayer

Tax considerations are never aside, especially in this newsgroup.

2.5% of _what_? If I can make a 2.5% margin on borrowed money, I'll do it in the billions (if I could). Seth
Reply to
Seth

Before you rush out to borrow those billions, remember that the OP said the 2.5% was before property taxes, insurance and maintenance costs. Also, what about inflation - are we assuming 0?

-HW "Skip" Weldon Columbia, SC

Reply to
HW "Skip" Weldon

Inflation is in the debtor's favor; he pays back the loan with cheaper dollars. (Income and costs other than mortgage rise together.) Seth

Reply to
Seth

OP's number are extremely simplistic, and ignore a lot of things that add to the value of owning real estate. For example the mortgage "cost" includes paying down of principal, which he banks but does not currently recognize. Real estate generally also appreciates in value, so he gets the multiplied value of that, since the increase is based on the full value of the property even though his down payment was only a fraction of that amount. Additionally, all the payments for mortgage interest, costs of upkeep, etc., are deductible from taxable income, though when the place is sold most income will likely qualify as capital gain and as a result will be subject to taxes at a lower rate. Stu

Reply to
Stuart Bronstein

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