View: You should defer or shield as much income as comfortably possible until retirement to minimize your present tax bill. The odds of your retirement income equaling your working income is slim-to-none. Therefore, your retirement tax rate will be much lower.
In the process of refinancing my primary residence mortgage down to around 2.5% for a 5/1 ARM, it dawned on me to also check what the rates are for my conforming rental mortgage. I just refinanced my rental property last year from a 30-year fixed at 5% down to a 5/1 ARM at 4% because I took a stance that rates weren’t going anywhere, and that I would pay off the loan in 5-6 years time. Mortgage interest rates are back down to all-time lows as of 1/20/2015.
It turns out that I can refinance my rental property mortgage down to 3.375% from 4% with no out of pocket costs. At 3.375%, all the costs are baked into the rate. Conventional wisdom says to refinance your mortgage whenever you see rates 50bps (0.5%) lower than your existing loan, with a break even period of 12 months or less. With a break even period of 0 months, and 75bps lower, refinancing now is a no-brainer!
My net income from this particular rental is around $1,000 a month. That’s after HOA dues, mortgage interest, maintenance, depreciation and property taxes. Not huge, but better than a poke in the eye. If I had no mortgage at all, the net income would be closer to $2,400 a month at today’s rent, which is an income stream I’ve been planning for since first purchase. Unfortunately, I pay about a 30-33% effective tax rate (federal + state) on the rental income thanks to the progressive nature of our income tax system.
Then a light bulb went on………….
HOW TO LOWER YOUR TAXES BY DOING A CASH-OUT REFI
Banks always want to make money, and one of the ways is by lending good creditors lots of money! The mortgage officer said that I could do a cash-out refinance up to 75% LTV of appraisal value. In other words, if the property appraises for $700,000, and I only have a $300,000 mortgage (43% LTV), I could cash out $225,000 ($700,000 X (0.75-0.43)) and increase my mortgage size to $525,000 ($700,000 X 0.75)!
Wouldn’t you like to have an extra liquid $225,000 lying around for only 3.325% a year to charter a private jet and make it rain in Vegas? Tempting! But realistically, let’s understand how doing a cash out refinance shields you from taxes.
A $300,000 mortgage at 4% costs about $1,433/month, and after all other costs, the net rental in this example yields $1,000/month. Meanwhile, a $525,000 mortgage at 3.375% costs $2,321 a month. The net rental income of $1,000 practically gets wiped out, which is a good thing, because now you won’t have to pay 33% taxes on it while working! That’s a nice $3,960 LESS taxes to pay a year thanks to a cash-out refi for now.
The other benefit of having $225,000 cash in the bank is that you can choose to invest, gamble, blow yourself up, or do whatever you want. Ideally, you would simply find a tax free and “stable” municipal bond fund that pays over 3.375% and hold it to maturity. There are actually tons of muni bond funds that pay over 6%. Finally, let’s say the property market absolutely detonates, at least you’ll have pulled out a good chunk of change and have something to show for it.
Only when you’re retired, and no longer earning an income that commands a 33% effective tax rate will you pay off the entire mortgage. During retirement, I expect my effective income tax rate to fall to 15%, thereby saving 18% (33%-15%) X $12,000 = $2,160 a year.
YOUR RETIREMENT INCOME WON’T EQUAL YOUR WORKING INCOME, SORRY!
People fool themselves into thinking that if they can make say $100,000 a year on average from their job, they can generate $100,000 a year in passive/interest income by saving and investing for decades. Newsflash! At today’s risk free rate of 2% on the 10-year government bond, you will need $5 million bucks to generate $100,000! And if you are in the top tax bracket and make say $1 million a year, you will need $50 million bucks to generate that level of income and pay the same taxes! This is the argument why paying taxes now and doing a ROTH IRA is dumb. It’s better than not saving, but tax planning wise, it’s foolish.
Stop deluding yourself into thinking you’ll be making the same amount of money in retirement. Your goal – especially for those of you in the highest income tax brackets – should be to pay as little taxes now, and defer as much income as you can comfortably allow during your retirement years to minimize your tax burden. The government isn’t putting your money to good use, and half the US population isn’t contributing any federal income taxes. As a result, you might as well not contribute as much either!
Wealth Building Recommendations
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Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns. Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible from them or your existing bank. When banks compete, you win.
Updated for 2019 and beyond.