Tuesday, December 06, 2005

The Tax Panel and Real estate investment

The President's Tax reform advisory panel submitted some proposals early in November. The proposal that caught my eye was the suggestion that the home mortgage interest deduction should be reduced. Rather than breaks for loans up to $1M, the number would fall to the average housing price in a region. I kept seeing descriptions of this, and all the money it would bring into the treasury.

I'm interested, of course, because I'm now a real estate investor. We now own two 4-plexes in Arizona, and continue to look for attractive properties. So I kept wondering, as I read all these media reports, whether the panel had suggested changing the taxes on interest for investors as well. Non-investors don't seem to have noticed, but interest on investment property is also deductible, but it's a completely different section of the tax code. Here's the scoop:

Home mortgage interest
interest you pay on a loan secured by your main home or a second home. The loan may be a mortgage to buy your home, a second mortgage, a home equity loan, or a line of credit.
Investment Interest
If you borrow money to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limit discussed later.

The limit was harder to locate, but here it is:

Limit on Deduction
Generally, your deduction for investment interest expense is limited to the amount of your net investment income.

I had to look pretty hard, but I eventually found a short paragraph describing the proposal's affect on investment interest:

Individual investors would be able to deduct the amount of interest incurred to generate taxable investment income. The deduction for investment interest would be limited to the amount of taxable investment income reported by the taxpayer.

That is to say, the panel's proposal would make no change in the deductibility of interest on investment property. This is one of the two largest factors making real estate such a lucrative investment. The other is that it's easy to leverage at 5 or 10 to one: Banks will lend you 80 or 90% of the money that it costs to purchase property. There are markets that are growing in value at 5-10% per year, and have decent prospects to continue growing. In most (outside of California), rents are sufficient to cover the expenses (including the mortgage.)

You have to put up the down payment, but then the property pays for itself, and you get both the appreciation and the amortization. Even if a market has a downturn (which is rare, and when it happens is usually reversed in a few years), if your cash flow is positive, you can wait it out. If you have an 80% loan, and the propterty appreciates at 5% a year, you are making 25% per year from the appreciation. Meantime, the rent, by paying down the mortgage, is also increasing your equity each year.

Obligatory libertarian statement on taxes: I don't consider it immoral to take advantage of tax incentives that provide ways of not having to pay taxes.

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