Recently I heard a real estate guy preach about how keeping mortgage debt is good because you don't lose the mortgage interest deduction. This is very misleading to a new investor who may not have a grasp on taxes and tax deductions and how they work.
First let me advise that I am not a tax professional. I would recommend talking to Maria Cerda if you have tax questions, she is a licensed professional. Let me explain why the mortgage interest deduction is not a good justification for not paying off debt:
1. Mortgage interest is a DEDUCTION not a credit. A tax credit reduces the taxes due....after you've run your tax calculation if you owe $1000 and you have a $100 tax credit, the tax bill is reduced to $900. This is a direct $1 for $1 write off. Great. Too bad mortgage interest is not a credit, it is a deduction. This means it only reduces your taxable income. Assuming your tax rate is 20% and you pay in $1 of mortgage interest, the deduction would reduce your taxable income by $1. The $1 deduction in taxable income X 20% = $0.20 savings on your tax liability. You're still down $0.80 for that dollar, it's not a wash as some people make it sound.
This next part does not really apply to a properly run rental business because if you're treating it as a separate business, the mortgage interest is an expense of doing business.
2. The small benefit is only received if you itemize your deductions. If you claim the standard deduction ($11,600 for married couples) then you receive no tax benefit for your mortgage interest paid. What this means is your itemized deductions MUST be more than the default $11,600 deduction to receive any benefit (if married, $5800 if single). If your only itemized deduction is $12,000 in mortgage interest, you think you are all clear. Sure, you are itemizing, however are you really receiving $12,000 in true deduction? Without itemizing, you get $11,600 deduction by default, with itemizing you're getting $12,000 worth of deductions. The true felt benefit is only $400 INCREMENTAL deduction ($12,000 itemized - $11,600 standard) .Take that $400 and multiply it by the above 20% tax rate and you only save an incremental $80 on your tax liability over the standard. You must ask yourself, is that worth $12,000 in interest paid?
If you want to talk to a seasoned tax professional that we recommend, email Maria by clicking here.
