Help a Reader: Two Mortgages

Here's an email I recently received from a reader:

Here is our current financial situation:

• I am 30; my husband is 31. 

• We have $50,000 in emergency savings and $25,000 in a separate brokerage account invested in various stocks, bonds, and index funds.  My husband fully funds his Roth 401(k); it has a current balance of about $50,000.  We both fully fund our Roth IRAs each year; I have a balance of about $26,000, and my husband's is about $13,000. (My balance is higher because I rolled over my retirement plan from my previous employer.)  We've also started a 529 plan for our one-year old daughter with about $3000 invested in it so far. 

• I am a stay at home mom; my husband's position, although new, is relatively stable.  His gross income is $130,000 annually. 

• We recently moved to a new state.  Because the market tanked, we decided to keep our old home, refinance, and rent it out.  After our mortgage, taxes, insurance, property management fees, etc., we net about $125/month.  This home has a 4.25% 15-year fixed mortgage with a current balance of $127,000.  Our payments are $1150/month including taxes and insurance.  I would guess the current value of the home to be about $250,000, and we bought it at $317,000.  We hope to sell this house when the market rebounds, but who knows when that will happen?

• We also purchased a home when we relocated.  This home has a 4.5%, 30-year fixed mortgage with a current balance of $278,000.  Our current payments with taxes and insurance are $1750/month. 

• We have no other debts.

Which mortgage should we focus on prepaying first?  We could obviously pay off the rental much sooner, but I don't know about all of the tax implications of the rental income and expenses.  Psychologically, it appeals to me to get this payment out of the way, but I don't think it makes sense financially.  Any input you or your readers might have would be appreciated.

What's your advice for her?

Comments

[KH]

You only get the tax right-off on the mortgage interest of the house you're actually living in. So you'd save money by paying off the mortgage on your rental first.

[Matt]

Consult a qualified tax advisor. Rental properties have depreciation and other write offs that help out considerably and prepaying the loan may be a determent.

My suggestion is to not prepay on either house until you are sure you want to keep the rental property or sell. Worse case scenerieo, The cash on hand may be needed to pay the rental house mortgage if no one is renting it at the time. 50K in emergency funds would go quick if all of a sudden you are looking at $3k a month in mortgage and other living expenses with total job loss.

[dd]

I believe a rental property enjoys the same tax deductions for mortgage interest as your regular home.
NOTE: There are other tax considerations for rental homes as well, but that's a different topic. For instance any major improvement / repair is an available amortized deduction depending on the IRS scheduled life cycle for that improvement.

As to early pay-off I would encourage you to work on your primary home since you are planning to sell the other one eventually. When it sells, I would then encourage you to take the equity of this rental and apply it to the mortgage balance of the primary home. If it is significant enough you can ask for a a "recast" which would allow you to modify the primary mortgage very inexpensively to reduce the payment. Of course you could also refi it if terms were significantly better, but given your comments I doubt that's going to happen.

As a side note, since you are now landlords you need to prepare mentally for the task. There will be unplanned repairs, tenant damages, potential rent payment issues, etc. Not trying to paint this as all bad, but hopefully to help you plan this as part of the overall experience. Then you're not reacting to a situation, but hopefully have a contingency plan. I'm sure the property mgt company helped you plan for this.

[dcs]

Honestly, my immediate thought is, if the only reason you are keeping the rental is "Because the market tanked" and not because you really want to be absentee landlords, then you've made a mistake. You've fallen into the loss-aversion trap, the equivalent of hanging on to a loser stock hoping it will rebound.

Right now you have about $123,000 in equity. What if it takes decades just to get that rental back to what you paid (in effect, back to zero loss but also zero gain)? Is that really the kind of return you're looking for on your $123,000 investment? Maybe get back to zero in ten years?

You say you're netting $125 per month. But does that include maintenance and repairs? Months when it's vacant? The additional liability insurance that I would have if I were a landlord? Even if those are accounted for in the net figure, is the $1500/yr in income worth it? To me it absolutely would not be, especially since a single month of vacancy plus cleaning/prep for a new tenant could push that rental into a net loss (in other words, costing you money) for the year

If it were me, I'd sell the rental, take the loss, and apply the ~$123,000 in equity to a refi of your current home into a 15 year fixed. Now the mortgage on the current home is cut in half with roughly the same monthly payment and a lower interest rate. That sounds like a much better investment to me.

[ajc @ 7million7years]

That's not correct; home mortgages are capped deductions (up to $100k loan?), rentals are uncapped.

How do they propose to replace a $130k (less mortgage) if they pay off their home loan and sell their rental. They should be buying more!

1. If I read this right, their rental is paying its own way - perhaps before depreciation benefits. Why sell or pay it down???

2. Their own home costs 'only' $1750 p.m. against net income of $6k to $7k a month (I'm assuming, based on $130k p.a. gross), so it's certainly affordable.

3. Paying down either loan is giving up a 4.25% - 4.5% loan to what ... take out a more expensive loan when everything is paid off and they're ready to invest???

4. They have $75k in cash doing virtually nothing for them, and they want to 'invest' it at 4.25% - 4.5% by paying down home loans? Put that money to work: buy another rental or two. If they can make them pay their own way from Day 1, like they did with the 1st rental then it's a no-brainer. Sure keep a buffer against vacancies and repairs & maintenance.

5. If a true emergency does arise, they should have plenty of equity to fund a HELOC to tide them over, or sell leisurely, if they feel they can no longer hold.

[rcc]

I suggest try to consult someone who is expert on this area because if you just try to get advises it won't matter a lot. Having two mortgages I think gives you risks but handling them well and prioritizing first the most important will give you so much relief. I'm not expert on this area but if you seek help to someone who understand tax more than we understood it will definitely solve your problem.

[JeffinwesternWA]

Don't pay the houses down, they probably are depreciaitng assets anyway. Consider selling the rental home before you are faced with capital gains, depreciation recapture (consult a CPA to run the numbers for 1-2 hours fee), etc., All extra dollars go toward emergency savings getting OVER a year+ built up (since you run the risk of an empty rental/unsold home as a negative cash drain). FULLY fund the IRA's still...after house is sold then invest for the future with MORE $$ in 401K and a tax efficient non-IRA that matches your portfolios goals/risk/asset allocation-diversification goals. (get a pro to help). Should you end up keeping the second home as a rental, look to increase the rent as maintenance/management/turnover (empty) will reduce your $1500~ a year profit to negative. If you can't get 1%+ of rent EVERY MONTH, based on TRUE market value of the home, then it is a poor long-term rental anyway...

[Everyday Tips]

I wouldn't pay down either mortgage. The rental is a revenue producer as it is, so I wouldn't mess with that.

I would probably keep some money for emergencies, especially since you only have one income at the moment. I would invest the balance in dividend funds, college, etc.

[Ladam8518]

Couple of notes:

Mortgage Interest:
1. Home mortgage interest can be claimed for a primary and a secondary home owned by the taxpayer on a Schedule A.

2. Mortgage interest on rental property is claimed on a schedule E. There is no limit to the number of rental properties that can be claimed.

Rental Deductions:
1. Depreciation can (and should) be taken as long as the property is rented.

Effects of Selling:
1. The IRS considers capital gain on the depreciated value of a rental property when it is sold. You are responsible for Capital Gains on the depreciated value regardless of whether or not you claimed depreciation.

Other comments:
You can use the rental to claim up to $25,000 in loss if you "actively" participate in the rental. Active Participation means you are involved in selecting tenants, decide on rental terms, arrange for outside parties to provide services to the property, and approve repairs or other capital improvements. Otherwise your loss is limited to your rental income.

When you sell or otherwise dispose of the rental property, you must reduce your basis (dollar amount paid or value of the property) by ALLOWED depreciation, thus increasing any capital gains that may be realized. The IRS does not care whether or not you claimed the depreciation, only that the property could have been depreciated. This can result in an unexpectedly high tax bill in the year of sale/disposition.
_____

As to the original question of which mortgage to pay off early, if any, I would personally go with the home mortgage and not the rental mortgage. This is because I would consider the rental as a business and be trying to separate it from my personal finances. I would see paying off the rental mortgage as lowering my net worth to increase my gains in passive income from an asset that would do that anyways.

Paying off your home mortgage will increase the amount of money available from money earned from sources that are subject to Medicare and Social Security tax as well as Income Taxes (Rental Income is not subject to Medicare or Social Security Tax).

Disclaimer: I work seasonally as a tax preparer for H&R Block specializing in rental returns.

[Sarah]

@Ladam8515 - you said the IRS considers capital gain on depreciated value - what if the value of the house never goes back up to the original sell price - depreciation? can you claim a loss? I'm clueless how this works, but am in the same situation where I am renting out a condo I own because we had no bites after having it on the market all summer. I hope to sell it when the lease is up (Our renter signed a two year lease - we have 1 year left on it), and am not hoping to make any money off of it. Currently i owe about what I could sell it for, which is hard to swallow since I put over 20% down when I bought it. We are breaking even on our renter, and I'd rather the hassle of it was just gone.

[Troy]

Wow. Alot of people really don't know what they are talking about regarding interest deductions, caps, depreciation. Ladam explained it correctly.

My opinion. I would sell the rental, take the proceeds and pay down the primary home loan balance to $155K or so (depending on selling expenses of course). Long distance landlording requires too many stars to line up and stay in line for too long for my risk appetite.

Waiting for the market to return. You may be waiting for a while. I would cut your losses, get out and get on with it.

[S.T.]

Thanks for all of your comments and advice so far. The biggest thing I've gotten from your comments is that we need to consult a tax professional this year to help us sort out all of the deductions as well as explain all of the tax consequences specific to our situation.

A few items to clarify:

1. Unfortunately, we have already incurred significant repairs since leasing the property in April. We had to do a re-pipe of the home, which cost about $5000. This is not part of the $125 net income each month, so for 2010 we'll definitely have a net loss. Our property manager told us that tenants will be more picky about problems that homeowners just decide to live with, and we learned that lesson very quickly.

2. We didn't live in the house for very long--about 18 months. I know for primary residences you have to live in the property at least two of the past five years. I'm not sure that it's applicable now that we've turned it into a rental property.

3. In response to Matt, we are also working to increase our emergency fund to at least $75,000. I've been putting about $400/month extra towards our mortgage on our primary residence, and everything else extra goes into the emergency fund.

All of you have given me a lot to think about. Our current lease is up in April, so we'll probably re-evaluate a few months before and decide whether to sell or re-lease.

[jim]

Do you WANT to be a long distance landlord for several years and have a large amount of equity tied up in a real estate investment? If you don't answer yes to this then you should definitely SELL that rental.

The reality is that the property values may not go up much at all in the next few years. You'll have risks of repair costs and possible vacancies. That mortgage is a liability that could bite you at some point. What if your husband loses his job and then your tenants move out the month afterwards? How long can you carry 2 mortgages? This isn't a veyr likely scenario but its possible, do you want to take that risk based on the desire to speculate on the property value going up some unknown time in the future?? Are there better things you could be doing with the equity you've got in that property?

[Mike B.]

"2. We didn't live in the house for very long--about 18 months. I know for primary residences you have to live in the property at least two of the past five years. I'm not sure that it's applicable now that we've turned it into a rental property."

As long as your selling at a loss, I don't see how this matters. That is only a caveat if you want to waive the capital gains--if you are losing money, that rule isn't helpful/hurtful.

[Troy]

Mike is right. The capital gains exclusion for couples is $250K each but you will sell at a loss, so there are no capital gains to exclude. So the timeframe of occupancy or ownership is irrellevant.

And while you will need to see a tax professional when you file your taxes, what you have been told here on the forum from Ladam is correct.

If you sell, you have no tax liability becasue you will sell at a loss. I would most definately sell. You have a lot of risk with two properties, one long distance, no guarantees of paying tenants, no guarantees of protection of your collateral from damages, and no guarantee of your single income remaining constant.

As I said before you are balancing based on all stars aligning perfectly. It works now because everything is going smoothly. But prepare for when things don't go too smoothly. Because that happens, especially with tennants and jobs.

[RobF]

I STRONGLY recommend Nolo Press' "Every Landlord's Tax Deduction Guide" by Stephan Fishman. Your reader should understand this book. It will really help them with the decisions and working with a tax preparer. It really helped me with creating a business plan for the student rental we bought. The readers can take advantage of the small landlord tax deduction. Having a management company helps with the out-of-state issue. They are not trying to manage at a distance. Another quick note - the basis for the property value as a rental is based on the value at the time it was converted to a rental. This is also the basis used for depreciation (less the value of the land).