Does it make sense to pay off mortgage on rental property?

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Does it make sense to pay off mortgage on rental property?

Postby ppt79 » Sun Feb 27, 2011 7:44 pm

I've been going back and forth for a while on this one, was hoping i could get some feedback from board members on this. I have the ability to pay off the 230K mortgage on the investment property and maintain a comfortable emergency fund cushion. I was wondering if I should pay it down OR allocate the cash to a tax exempt muni bond fund or the vanguard long term tax exempt fund admiral shares with hopes of getting the approx the same after tax yield with the added benefits of either fund being more liquid than the rental property. Many thanks in advance.

Here is the situation:


Early 30s - Filing status Married filing jointly

Debt 630K mortgage spread across primary residence and rental property. We have about 430K total in equity across both properties

400k @ 28 years 4.675
230K @ 30 years 5.125

Tax Rate 33% Federal, 6.37 State

Current PortfolioLow 7 figures in a portfolio consisting of various vanguard ETFs. Majority is taxable, 401ks are being used for the fixed income portion of the portfolio for tax efficiency
Domestic Stock ~50%
Foreign Stock ~30%
Fixed Income~ 20%
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Postby Zippy01 » Sun Feb 27, 2011 9:18 pm

You didn't mention your income, but I'm guessing your cash flow is good. I'm also guessing you benefit from the mortgage interest deduction on both the rental and your primary residence.

Not running any numbers, I think in your case it's more a psychological decision than anything. How good would it feel to be completely debt-free and have a seven-figure portfolio? VERY GOOD. I guess I'd be more inclined to pay off my primary residence if I were you, for tax reasons and peace of mind. (the rental is probably better for tax purposes.)

In that case, I'd put the money somewhere stable and save until I could pay off the primary mortgage in its entirety. If you opt to pay off the rental, you're lucky and smart to be doing it in the early years when the interest you're paying is so lopsidedly in favor of the lender.

No wrong move, no matter which of your options you choose.
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Postby Sammy_M » Sun Feb 27, 2011 9:45 pm

I think it depends on whether you're presently realizing the tax benefits of the rental property interest deduction. With depreciation and interest, you may have rental losses on Schedule E? If so, and if your MFJ income is over $150K, you're not realizing the tax benefit right now because you can't offset the rental losses against regular wage income. You don't lose it per se, but it gets deferred. Make sense?

And don't forget you'd be taking risk in those bond funds that you'd not be taking if you paid off the rental mortgage.
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Postby ppt79 » Sun Feb 27, 2011 10:02 pm

Sammy - first thanks for the response. I did show a loss on the property this year on the schedule E but can't take advantage due to my income. The plan was to bank the losses and use them to offset any potential capital gain I may have in the future when we decide to sell. If I pay down the rental property mortgage I don't think I can show a loss every year going forward. In the end it might come down to the fact that a bond fund would be more liquid than the rental property. Thx again
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Re: Does it make sense to pay off mortgage on rental propert

Postby grabiner » Sun Feb 27, 2011 10:45 pm

ppt79 wrote:400k @ 28 years 4.675
230K @ 30 years 5.125

Tax Rate 33% Federal, 6.37 State


Can you deduct the mortgages on your state taxes? I suspect you live in NJ, given that the tax rate is 6.37%. NJ doesn't allow deductions for interest on a home mortgage, but does for a mortgage on a rental property if you deducted it on Schedule E.

If you can deduct only the 5.125% mortgage on your state taxes, then the effective tax rate is 3.21% on that mortgage (37.25% combined federal and state tax bracket), and 3.13% on the 4.675% mortgage (33% federal bracket only). Even so, those rates are low enough that is probably worth keeping both mortgages as long as they are deductible. However...

I did show a loss on the property this year on the schedule E but can't take advantage due to my income. The plan was to bank the losses and use them to offset any potential capital gain I may have in the future when we decide to sell.


This is not as valuable a benefit. When you sell, your capital gain will be taxed at 19.25% (15% federal, 6.37% state deducted from federal). Thus, if you carry over a $1000 loss to offset a subsequent capital gain, you are saving $193 in taxes in some future year, which is not even as valuable as saving $193 in taxes this year. Even if the losses offset future income, $373 in some future year is worth less than $373 in this year. And the longer it is until you sell, the less the tax savings is worth; this counteracts the fact that the benefit from paying down the mortgage is also less valuable.

Thus, I would recommend paying down the rental mortgage up to the point at which the rental breaks even for tax purposes. Once the rental is breaking even, reducing the mortgage interest by $1000 saves you $373 in tax in the current year, and then it is worth keeping the rental mortgage.
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Postby Sammy_M » Mon Feb 28, 2011 8:55 am

I'm with grabiner on this. I'd only add that if you have a bunch of carryforward losses already, you might go ahead and pay off the rental mortgage and let your profits start using them up.
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