Tax implications of converting your home to a rental …


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Despite the length of this title, today’s post will be really short … because I have NOTHING to add on the subject of taxes. They are something to be paid – or not paid – depending on the advice of a QUALIFIED tax practitioner (accountant and/or attorney) in the area that you are interested.

Personally, I have only a slight hiccup in signing tax checks for over $1 Million (as I have for the last 2 tax years in a row) because it means that I have made a TON more money 🙂

… and, I rely totally on good advice; but, I pay for conservative, specialist opinion where necessary.

However, I have noticed that I number of my readers (and contributors) have recently converted their own residences into rentals, so I thought that I should perform a Reader Service by pointing you directly towards the excellent Tax Tips Blog so that you can read some excellent advice, straight from the “horse’s mouth”:

Disclaimer: I have NO IDEA whether this is good, bad or indifferent advice … that’s what your accountant is for! 🙂

But, I would like your opinion

Instant Net Worth Fix?


What is the relationship between your income and your Net Worth? Does paying down a mortgage increase your Net Worth … these are the comments made by Diane to a reader who said that they had income that was going into CD’s, but still had a mortgage:

[If] you are paying down your mortgage some – rather than just interest …  then your net worth may be going up [?]

I told Diane that it doesn’t work that way ( Where Diane is right that putting money into CD’s while you hold a mortgage is probably a sub-optimal financial decision, it’s NOT because your Net Worth would change … paying down your mortgage does NOT change your Net Worth – it just reduces both your CASH (on hand) and MORTGAGE balance columns in your NWiQ profile …

… your total of Assets – Liabilities (hence, your Net Worth) remains the same!

Diane took me to task:

I assume [that you would be] applying income to [your] net worth and that is NOT reflected in the assets/debt columns of the networth calculations – it’s future cash for the most part (those who have incomes ;)) — or did I miss how else the income is reflected other than as a header above (along with our education)???

These are very good ‘technical’ questions, that I can explain (for those who are business/finance minded) as follows:

Income/expenses is/are a bit like a business’ P&L (Profit and Loss Statement), and your Net Worth is like a Balance Sheet … the former is a ‘work in progress’ and the latter is a ‘snapshot’ at a specific point in time.

Both cash and loans sit on the Balance Sheet … or, in our case, on our statement of Net Worth. Simply moving amounts around does not change either. Your Balance Sheet only changes if you make or lose money, grow or reduce assets (as long as you are not turning them into cash or some other balance sheet item).

Similarly for your Net Worth: decreasing a positive bank balance (on one side of your Net Worth statement) in order to similarly decrease a negative house balance (a.k.a. a mortgage) on the other side hasn’t changed anything – except where you keep various components of your Net Worth.

On the other hand, earning more profits (reflected in a businesses P&L) is similar to earning a salary or other income for a person (income) provided that you don’t spend it all (expenses) …

… they all help to increase your Net Worth (or improve the value of the business, as reflected in an improved Balance Sheet).

BUT, it doesn’t matter if you ‘store’ that extra income in a bank account (i.e. the CASH column of your NWiQ profile) or in your mortgage (effectively reducing it) … your Net Worth goes up by the amount of income that you saved since you last calculated your Net Worth.

As Scott says:

As long as you are living in your home, it is a liability and costing you money if anything.

That is, unless you are prepared to tap into that home’s equity and use that money to invest.

Yes, it’s what you ’save’ from your income (i.e. after expenses) that goes into improving your Net Worth regardless of whether you use it to build up your bank balace, pay down debt, or – as Scott suggests – buy a new asset.

We're split down the middle …

… some agree that paying down your mortgage is the dumbest decision that you can make (not really the dumbest …. but certainly down there with the best – I mean, worst) and some simply don’t agree.

Right now, though, I want to pick up on one of Nick’s comments, since he has summed up the ‘pro-pay down argument’ really well:

I do a decent amount of investing myself, and while I don’t claim to be a master of the trade, I do well. That doesn’t change the fact that I don’t know how my investments will turn out. Everything could go horribly wrong, and I could end up taking quite a hit… or it could go really well and I could make a killing.

I don’t think anyone really knows for sure how well their investments will perform. I think anyone who does is either lying or fooling themselves. It is all about managing risk.

Putting a sizable portion of your cash as a down payment, and making prepayments to pay off your mortgage, is very good way to minimize risk. You end up with lower monthly obligations, less debt, more equity… Of course, this means less free money to invest and less money making potential..

Once again though, risk management philosophy comes into play. Is your primary residence something you want to take the risk with? In today’s market, putting less down, and making lower payments would turn out to be a very costly mistake if your investments don’t net the return you wanted (you’ll be stuck paying up to hundreds of thousand of dollars more in interest over time).. and this is only assuming you merely break even on the money you invested (and are not in the red).

I think everyone’s long term plan involves moving to a nicer house in a nicer area. This is something perfectly attainable by playing this situation safe. IMO, it is dangerous to put such basic life plans on the chopping block. I think this is how people could potentially get into serious trouble.

Now, don’t get me wrong. I’m not saying that you should immediately put any money you have towards prepayments, or you should put all your money down on that new house. I’m saying that you need to carefully balance this based on your confidence about making good investments and the amount of risk you are willing to take. In other words, I think its foolish for just about anyone to put very little down and not make prepayments when they can (i.e. tax return time, or portions of a raise). I think its equally foolish to put ALL of your money towards prepayment and down payment.

Make no mistake, that large down payment is a very good protection plan when you lose your job, your wife has a kid, or you encounter some medical emergency. Those lower monthly payments make things more manageable and prevent you from being overrun with debt.

A prepayment of only $300 a month on a $350,000 principal can save you well over a hundred thousand dollars in interest over 30 years. That money goes straight into your bank account or investments when your mortgage is paid off early.

These items are your safety net… and that’s part of good risk management isn’t it? To maximize gains and minimize risks. You can’t just focus on maximizing gains – you need to protect against potential pit falls as well.

By all means have your money work for you, and try to get investments that produce greater returns than your mortgage rate… but start off by minimizing your monthly payment (sizable down payment) and put a good effort in to pay your house off early (prepayments)… You know, just in case those investments don’t work out.

I have some questions of my own; let’s use Nick’s $300 per month example:

1. Is the $300 a month a sizable proportion of the amount that you intend to invest overall? If so, do you know what you are getting for it?

Nick says that paying down his mortgage by an extra $300 per month will save him $100,000 in interest over 30 years … let’s accept that number for now and assume that this $100k can be somehow freed up at the end of the 30 year period:

$100,000 in 30 years will have almost the same buying power then as $31,000 does today (assuming that inflation averages just 4%).

That should provide Nick a yearly stipend of just over $1,500 in today’s dollars (commencing in 2038, assuming that 5% can then be ‘safely’ withdrawn each year).

Now, there’s a problem right there; how can 5% be a ‘safe’ withdrawal rate in 2038?

If inflation is still just 4% Nick needs to find a ‘safe’ investment that will return him 9% after tax (4% to keep up with future inflation and 5% to spend) … he can’t get that return in retirement by paying down his mortgage any more, it’s already paid off!

So, now – in retirement – he has to look for a more ‘risky’ investment than the one he used to get there!

Therefore, I am assuming that Nick will either keep his paid off house and actually entirely forgo this income entirely or move into a smaller paid off house or unit to free up $100k of equity …

… in any event $1,500 or zero a month sounds pretty similar to me 🙂

2. Do you know what returns you can get elsewhere?

Even if Nick isn’t relying on this $100k (then why bother with it in the first place?!) – because he is also  investing elsewhere – what could he achieve if he also invested his $300 a month elsewhere?

Well, Nick is ‘saving’ 6% interest in the current market [AJC: if you aren’t prepared to fix an incredibly low interest rate like this, how can I help you?!], which could be equivalent to a 7.5% – 8% after tax investment return.

[AJC: Unlike investing in income-producing investments, there is possibly no income tax to be paid on your mortgage interest payments/savings … of course, there could be a tax disincentive if you have been itemizing your home interest on your tax return and can no longer claim that deduction]

But, what if he can find an investment that returns more than 8% after tax?

Even an extra 1% (after tax) additional return will improve Nick’s 30 year outlook by 20% (at least, for the $300 monthly extra that he is putting into his mortgage).

3. Do you care?

For me, this is the key question: can Nick achieve his financial goals even without investing this $300 a month elsewhere? If he can’t, is he willing to let these goals go for the apparent ‘safety’ of a home partly or fully paid off?

So, my real question to Nick is: can you achieve your financial goals at the same time as paying your mortgage off? It’s possible (hell, I did it!) but, for most people, not likely … they are already skating too close to the wind even before pulling extra money out of their investment portfolio.

To me, it’s the same thing as asking if you can fish for trout in a babbling brook without getting wet:

It’s possible, but you won’t probably won’t make a great catch unless you are prepared to (slowly, carefully, and not deeper than you can handle) wade in …

Pay cash for your house?

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at ….


We have dealt with the concept of how much ‘house’ you can afford while you are still working, but what about when you ‘retire’ (young … very young!); that is the question posed by Ryan:

Regarding “the number”. I know you’ve touched on this briefly before, but when considering a multi-million dollar home to live in during retirement, would you suggest putting in a number to rent or to pay for a mortgage? If for a mortgage, do we assume a certain percentage down? And what kind of interest rate can we assume we’ll get in 10-20 years?

We basically have three options when acquiring a house:

1. Pay Cash

2. Take out a mortgage

3. Rent

The rental optionn is actually not so dumb in the high-end bracket, as rents tend to fall way behind house prices (hence mortgage payments) … just check out what you can rent for $40,000 – $50,000 a year compared to what the same level of mortgage payment (assuming a reasonable deposit of only 15% – 25%) will get you.

But, let’s also assume that your idea of ‘retirement’ isn’t to pack up and shift houses every couple of years so that leaves us with paying cash or financing.

The first thing to realize is the fundamental difference with buying a house when you are working and when you aren’t:

When you aren’t working all the money that you have is what you have already manufactured …

… so, all you are doing by mortgaging or paying cash for a house is shifting money to/from your house from/to your ‘retirement nest egg’.

Let’s look at an example:

You decide that you need $100,000 a year to live off (before considering mortgage payments) but you want to retire into a nice $750,000 townhouse … your current house, after you pay back its mortgage will provide $250,000 of that, leaving you to ‘find’ $500,000.

Not exactly Ryan’s “multi-million dollar home” but it’ll do for the sake of this exercise …

Scenario 1 – Pay Cash for the House

Let’s see; we need:

a) $500k to pay the cash upgrade to the nice townhouse (on a golf-course, of course!)

b) $2 Million (according to the Rule of 20) to deliver $100,000 (indexed for inflation i.e. so next year it becomes $105k; and so on) living expenses.

So, we can afford to ‘retire’ as soon as we have built a $2.5 Million ‘nest egg’ …simple!

Scenario 2 – Borrow Money for the House

Now we need:

a) $2 Million (according to the Rule of 20) to deliver $100,000 living expenses

b) Another $1,100,000 (according to the Rule of 20) to generate the $4,500 monthly mortgage on the $500,000 townhouse balance (assuming 6.5% fixed interest for 15 years), plus $20k closing costs

Now, we have to wait to retire until we have built a $3,100,000 ‘nest egg’

But, it is actually a wash because we can afford to use the Rule of 10 on the mortgage payments rather than the Rule of 20 … why?

The mortgage is a fixed dollar amount: $4,500 every month for 15 years. If we consistently achieved 10% return on our investments, we would only need $540,000 set aside to generate the required monthly payment.

Then our total nest-egg would be $2,560,000 or a virtual ‘wash’ either way … but, this is heavily interest rate dependent:

– if interest rates are low and investment returns are high: mortgage.

– if interest rates are high and investment returns are low: pay cash.

Since you won’t know which way to expect the interest / investment markets to be aligned when you do retire in 5, 10, or 20 years, my advice is to plan to pay cash …

… calculate your Number using Scenario 1.

That’s what I did … then when I get the urge to invest a little of my home equity, I simply turn up the juice on the HELOC that I have sitting there ‘just in case’ and hop in / out of the investment markets as is my desire.

How much to spend on a house?

In a previous post, I weighed in with my thoughts on the Rent v Buy question. The answer for most people, at some stage in their lives, is to … buy.

But, how much to spend?

Boy, this is a biggie! I mean, your house is usually your biggest personal purchase. So, here goes …

You should INVEST no more than 20% of your Net Worth into your house!

[To calculate your net worth, try this calculator at , then come back and read on, because you need the second half of the equation …]

The ‘20% Rule’ tells you how much of your current net assets you should INVEST, it doesn’t tell you how much house you can actually afford to buy …

… because, houses can be financed!

So, the 20% rule tells you how much deposit you can afford. And, the bank will then tell you how much you can afford to borrow (unfortunately, they won’t tell you how much you SHOULD borrow … only how much you CAN borrow).

Put your deposit + mortgage together, and there’s your house!

For example, say that you have saved $200,000 and it is sitting in the bank. And, assume that you have a job, but no other income or assets. Then you can afford to put down a $40,000 deposit on your house; the bank will look at your income and tell you how much you than then afford to borrow.

Why 20%? After you ‘invest’ another 5% of your Net Worth in ‘stuff’ (car/s, furniture, possessions), it means that you are never investing LESS THAN 75% of your Net Worth (that would be the $150,000 that you have left in our example) in income producing assets (like investment property).

It also tells you that you should never build up more than 20% of your Net Worth as equity in your own home without then borrowing against the remaining equity to invest.

So you should conservatively revalue your house at least every 3 – 5 years and withdraw any excess equity and add it to your investment pool!

If you can’t afford to trade up to a bigger house without breaking this rule … don’t trade up! When you get rich later, you’ll be happy you waited now.

But, if you can’t buy your FIRST (very small!) house without breaking this rule, then buy it anyway … as soon as you have enough equity, borrow against it to invest in long-term, income-producing assets, and keep rechecking this post.

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Should you rent or buy?

Should you own or rent? I have seen a lot of rubbish written on this subject … stuff like “renting is just dead money” or “a house is a liability” … so let me set you straight:

 If you are just starting out, up to your eyeballs in debt, unemployed, or you just can’t afford a house right now, it’s simple: you just rent.

If you already own a house, don’t sweat it, keep owning.

 And, if you are ready, willing and able to buy your first house, or you are thinking of trading up (or, down) …. here’s my advice:

Put aside the emotional decisions and just consider the financial impact, and that is: your house is the ONLY way that most people will ever get off the launching pad to financial success …

Why? Because, you are building up equity over time (even a flat or falling real estate market eventually climbs back up again) …

… but – and here is the key – ONLY if you are prepared to put the equity in your house to work for you … that means, borrowing against the equity in your house to INVEST.

Now, if you are buying a house with 10% – 20% down, this won’t be until you pay it down a little and the market picks up a little.

But, when you do build up enough equity in your house to borrow against, you’d better be prepared to do it! If not, then you are FAR better off just renting and investing the money you save on mortgage payments every month …

… if you’re not prepared to even do that, stop reading this blog … you will never be much better off than broke.