Rental Property Financing

[semi-fired]

Hi all,

I'm considering picking up a residential rental property in the small Missouri town I live in, and there are some options as to how I can finance it. I'd like to get your opinions on them, including tax implications of each.

Option #1: I can pull the entire purchase price out of the equity of my residence. My current loan on my home is about 20% of the value of my house. The note is held by a local bank, and they'll rewrite the note at no charge to me. This is probably the easiest option (20 minutes of my time and no $$ cost), but I'm concerned about the tax implications. I'll get the normal personal writeoff on interest, but I assume I'll have to pay income taxes on the rent (minus prop taxes, insurance, expenses) as I won't have a mortgage payment to offset it (I'll still have a mortgage payment of course, but it'll be combined with my own home's mortgage).

Option #2: My bank will write a loan backed by CDs I have at the bank, 2 points above what they're paying me. This locks up my CDs however, and what's the point of making less on my cash if I lose the liquidity.

Option #3: I go get traditional financing on an investment property, and I assume I'll pay the market rate for a commercial loan, which is 1-2 points higher than primary residence loans? And I'll have to come up with 20% down.

Let me know what you think. Thanks in advance.

 

[Deadbeat]

I prefer having a loan of 65% to 80% of the houses value and letting the house/renter pay it off. I put enough down to have positive cash flow after all expenses and plan on 11 months of rent per year.

I would use traditional financing rather than tying other property to the rental. It makes things easier if you sell.

 

[tryan]

What's the difference between the prime rate and the CD rate? If the prime rate is lower than the CD rate and you've got the cash in CDs to pay off the note, I'ld use the primary residence for the lower rate.

 

[Meadbh]

I prefer having a loan of 65% to 80% of the houses value and letting the house/renter pay it off. I put enough down to have positive cash flow after all expenses and plan on 11 months of rent per year.

I would use traditional financing rather than tying other property to the rental. It makes things easier if you sell.

I agree. In this country you need 25% down on investment properties. I leverage to the maximum extent that is compatible with positive cash flow. I also am part of a program that works with mortgage brokers to obtain the best possible rates.

 

[semi-fired]

I'll definitely be financing. The question is do I back it with my house (good rates, easy), my cash (good rates, easy) or a new commercial loan backed by the rental property (bad rates, difficult).

I'm leaning towards backing it with my house, but am concerned about the tax implications of doing so (writing off P&I against rental income versus the personal mortgage interest deduction).

 

[Buckeye]

I would not tie up any other assets (personal residence or CD's) to finance a rental property, especially since it sounds like you are a new landlord (you don't even understand the tax implications). Seems like financing the property on its own merits brings you the least amount of risk. If the rental property situation goes to cr*p, you will need flexibility (like taking out a HELOC or cashing out CD's) to take care of the situation.

Hopefully, you have read the threads asking "should I become a landlord?"

 

[semi-fired]

I would not tie up any other assets (personal residence or CD's) to finance a rental property, especially since it sounds like you are a new landlord (you don't even understand the tax implications). Seems like financing the property on its own merits brings you the least amount of risk. If the rental property situation goes to cr*p, you will need flexibility (like taking out a HELOC or cashing out CD's) to take care of the situation.

Hopefully, you have read the threads asking "should I become a landlord?"

Thanks for responding buckeye.

I have been a landlord in the past (late night calls, "I'll have the rent money in a few days," etc.) and think I understand the tax implications in general terms, but wanted insight from others with more experience.

It's my understanding that if I finance the property separately, I will pay a point or two more in interest because it's an investment property. Tax-wise, the property income and expenses will be accounted for on a separate schedule, with rental income, loan interest, prop taxes and other expenses accounted for. Additionally, depreciation will have to be tracked.

If I simply pull equity out of my current home loan (zero cost) it will raise my loan-to-equity from about 20% to 40%. That's an increase in liability for sure, but not an outlandish risk my any measure.

My main tax concern rests in attempting to weigh the differences between claiming the additional interest deduction on my own home (at a lower interest rate) versus deducting the interest expense on a distinct loan on a separate schedule.

 

[FANOFJESUS]

I think borrowing against your home would be the cheapest money you could get your hands on and a tax deduction. The CD money could be used for the stock market.

 

[HpRyder]

My main tax concern rests in attempting to weigh the differences between claiming the additional interest deduction on my own home (at a lower interest rate) versus deducting the interest expense on a distinct loan on a separate schedule.

Interest on an additional loan up to 100K is probably going to be deductable on you personal itemization schedule A. This new loan interest deduction is limited by the interest on the total personal residence loan amount being less than the purchase loan + 100K. There are some other property improvement exceptions, but for the most part this may be your limit. And of course, the deduction may be limited by any other limits imposed on your itemized deduction schedule A.

For a rental property securing loan, the interest contributes to property expenses. If the net income – expenses (including depreciation) is too large a loss, it probably will be limited. The limit may be the 25K rental income loss cap or apportionment with other schedule E rental expenses, or your income being beyond an allowed rental loss threshold.

I would use TurboTax to run some what ifs to see what is best for your situation.

 

[semi-fired]

hpryder,

Thanks for the info. I always forget that you can run numbers on the TurboTax site for free. That's a great suggestion.