Use $72K for rental property or refinance?

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Dear Dr. Don,
I have a rental property on which I owe $72,000 at 6.75 percent. I have 24 years left on the loan. The monthly payment is $518. I also have a mortgage on my home with a balance of $401,000 at 5.25 percent and 28 years remaining on the loan. The monthly payment is $2,275. I have saved $72,000 and I am wondering if I should pay off my rental property or refinance my home and put $70,000 cash in to reduce my monthly payment. At a 3.87 percent interest rate, my house payment would be around $1,650 — saving about $600 per month. Are there any tax implications that would make one choice preferable? The estimated closing costs on the refinancing are about $4,000.
–Christos Choice

Dear Christos,
The tax implication of paying off your rental property is that you’ve eliminated the interest expense on the property, and more of your rental income will be subject to income taxes. You get out from under a high interest rate, but you lose the interest deduction. The value of the interest deduction on the rental property can be valued as your marginal federal income tax rate times the interest expense.

The table below illustrates an example of how paying off an income property loses the interest tax deduction but still results in higher income to you.

Pay off mortgage on a rental property?

Rental Property With Mortgage Mortgage- Free Difference Difference Explained
Projected Revenue $36,000 $36,000    
Interest expense $4,860 $0    
Earnings before tax $31,140 $36,000    
Income taxes at 25 percent $7,785 $9,000 $1,215.00 Lost tax deduction without mortgage
Net Income 23,355 $27,000 $3,645.00 Higher income without mortgage

I wouldn’t rush into a cash-in refinancing on your primary residence. The only reason I see to do a cash-in refinance in your situation is if you can’t get a loan otherwise.

The goal should be to reduce your overall interest expense. Using your $72,000 in savings to pay off the 6.75 percent loan makes more sense than using the money to do a cash-in refinancing on your personal residence.

I like the idea of mostly paying off the rental property, keeping $4,000 of the $72,000 of savings to pay for the closing costs in a refinance of your personal residence at the lower rate. You’re planning to borrow at 3.87 percent pretax. Assuming you can fully utilize the mortgage interest deduction on your income taxes, your effective rate could be less than 3 percent.

All of this presumes that you have an emergency fund of three to six months’ worth of living expenses, and that you aren’t a real estate professional. If you are a real estate professional, you should be working with your accountant and not writing in for free advice.

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