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I met with a financial advisor for the first time yesterday (trying to get my things in order for retirement). During our meeting he told me a story that sounded pretty impressive, but the more I think about it, the more I don't understand how it would work.

I have a rich client who is retired. He was paying a fortune in taxes. I advised him to take out a mortgage on his already paid off house. Thanks to the deductions the house gave him, he actually paid less on the mortgage and his taxes than he was before.

(This is all in the US, by the way.)

He went into more detail about how it was tricky to get the mortgage and it all sounded very creative. But my very limited understanding is that this is impossible. The deductions you get from the interest on your mortgage will reduce your taxable income, but it's only going to reduce your tax burden by something like 30% (optimistically).

If I reduce my taxable income by $1, and I'm paying 30% in taxes, I've saved .30 off my taxes, but I still have .70 less than I would have if I just did nothing. At least, that's how I understand it.

Now, I get that it's different if you are comparing renting a house verse buying a house - because things like the value of the home become a factor. If the house appreciates or depreciates it changes the numbers drastically - but in this story, the guy already owned the same house, so it has no impact.

This guy is a professional and had a bunch of certifications and what not on his desk....but it just sounds completely wrong to me. Can someone explain what I'm missing?

  • 13
    The obvious way you make money doing this is if you use that mortgage to buy another house and rent it out for more than the interest portion of your mortgage payment plus overhead costs. But then it's a business plan, not a tax cheat. – R.. Nov 16 '15 at 16:08
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    I read about people who tried to make money by mortgaging their paid-off house to invest in Bernard Madoff funds with guaranteed 11% profits. You know how it ended up. – Peter M. - stands for Monica Nov 16 '15 at 19:38
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    @PeterMasiar: The level of stupidity it takes to "invest" with someone whose name is literally "made off" is just unbelievable. :-) – R.. Nov 17 '15 at 4:05
  • I read an article written by a professor of economics, who invested (and lost) part of his retirement savings with Madoff. He wrote how he convicted himself (a professor of economics) that Madoff must have some secret knowledge. Even experts can be misled by good enough con man. – Peter M. - stands for Monica Nov 17 '15 at 19:38

10 Answers 10

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To keep the math simple, say you are in the 25% federal tax bracket. Your 4% mortgage effectively costs you 3%. Did Mr Advisor tell you what he suggests investing the money in? Borrowing at 3% net to put the money in .1% CDs makes little sense. And for most people, investing it in the stock market hoping to come out ahead, also makes little sense.

Credentials or not, people like him give humans a bad name, and make me love my dog even more. I'd stay far away from this guy. Very far away.

Edit - on further reflection (seeing mhoran's reference to $100K) it occurred to me that once a house is paid off, the only deductions allowed is for the first $100K of new mortgage or HELOC, absent a renovation or improvement of some kind. Given the limit and current 4% rates, it would seem to me that a rich retiree paying a fortune in taxes, isn't going to benefit much for a $4000 deduction.

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    +1, but I wouldn't take financial advice from a dog either. . . – BrenBarn Nov 15 '15 at 19:07
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    Ahh - okay, I think I get it. If the mortgage is at 4% and with the tax deduction maybe it's really more like 3 point something; if you take the money from the mortgage, and invest it, and it returns more than that 3 point something, it's a profit. He didn't mention the investing part, so I assumed it was strictly with tax breaks. Thanks – Rob P. Nov 15 '15 at 19:55
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    Borrowing at 3% net to put the money in .1% CDs makes little sense. And for most people, investing it in the stock market hoping to come out ahead, also makes little sense - Maybe I misunderstood, but if the mortgage interest rate is sufficiently low (sub 4%) and given that index funds have traditionally returned over 7%, couldn't you (statistically) come out ahead over a 30-year mortgage? Even leaving aside the tax deductions? The advisor does sound too "slick" for me, but it's not an implausible story is it? – Jay Nov 15 '15 at 20:26
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    Even if it was true, bragging about helping rich people get richer by paying less tax is in itself rather dubious. – tomasz Nov 15 '15 at 23:29
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    @BrenBarn - my dog would advise me to buy more food. I'm okay with this advice... – Jon Story Nov 16 '15 at 10:23
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Imagine a married couple without a mortgage, but live in a house fully paid for. They pay state income taxes, and property tax, and make charitable deductions that together total $12,599. That is $1 below the standard deduction for 2015, therefore they don't itemize.

Now they decide to get a mortgage: $100,000 for 30 years at 4%. That first year they pay about $4,000 in interest. Now it makes sense to itemize. That $4,000 in interest plus their other deductions means that if they are in the 25% bracket they cut their tax bill by $1,000. These numbers will decrease each year.

If they have a use for that pile of cash: such as a new roof, or a 100% sure investment that is guaranteed make more money for them then they are losing in interest it makes sense. But spending $4,000 to save $1,000 doesn't.

Using the pile of cash to pay off the new mortgage means that the bank is collecting $4,000 a year so you can send $1,000 less to Uncle Sam.

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    You know, for as simple as that math really is, I'm always astounded about how many people seem to want a mortgage interest deduction for its own sake. Like, really? – enderland Nov 16 '15 at 3:11
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    But if making more than the 4% of interest with the cash, wouldn't that increase taxable income? Deduct the 4%, add back the "more than 4%". – Jost Nov 16 '15 at 18:58
  • Not if the money were invested in tax-privileged accounts, which the financial service representative probably sells. – Aaron Hall Nov 16 '15 at 21:08
20

Sounds like a poorly written piece at best...

The way you make money with a mortgage, if you're careful and/or lucky and/or patient, is to use that loan to make leveraged investments. If the return on the investments is higher than the interest on the loan, you win. Of course if the investments don't do well you can lose money on this deal... but at current interest rates it isn't that hard to make a profit on this arrangement, especially if you can get the tax deductability helping you.

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I think this is possible under very special conditions. The important part of the description here is probably retired and rich. The answers so far apply to people with "normal" incomes - both in the sense of "not rich" and in the sense of "earned income."

If you sit at the top tax bracket and get most of your income through things like dividends, then you might be able to win multiple ways with the strategy described. First you get the tax deduction on the mortgage interest, which everyone has properly noted is not by itself a winning game - You spend more than you save.

BUT... There are other factors, especially for the rich and those whose income is mostly passive:

  • The deductions may drop their income tax bracket, which will reduce their overall taxes by an additional amount. This is 4.6% (marginal rate) from the top bracket to the second highest bracket (using 2015 rates).
  • The qualified dividends and long-term capital gains rate also changes on a marginal basis at the very top from 15% to 20%. If he has a lot of passive income, he might save 5% on a reasonably big number.
  • Depending on all of the details of his tax situation, he might jump from AMT to regular tax, which has a complicated impact on the total tax.
  • Since the person is said to already own the home, he's going to have a pile of cash after getting the mortgage. That all comes to him tax free because it is not income. He may be able to live off of that cash vs., say, selling capital assets to generate income in his retirement. He thereby saves additional tax by not generating (or at least deferring) income that he otherwise would have had.

I'm not motivated enough on the hypothetical situation to come up with a detailed example, but I think it's possible that this could work out. In any case, the current answers using "normal sized" incomes and middle tax brackets don't necessarily give the insight that you might hope if the tax payer really is unusually wealthy and retired.

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    Thank you. Clearly there is a lot more going on with taxes than I'm aware of. – Rob P. Nov 16 '15 at 2:40
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I came up with a real way. I saw once the market be so dumb as to allow this to work. Inflation rate = 2.5%. Home interest rate = 3%. Tax deduction = 1%. Money spent on inflation-adjusted I bonds (at the time these paid 0% net, that is 2.5% gross). Result, .5% profit after accounting for inflation. The kicker: Uncle Sam's I bonds are tax free.

Sure it's not possible today, but the rates occasionally drop low enough.

  • Nice try, really. One may not borrow to invest in tax free bonds. Or rather, the interest can't be deducted. +1 for the observation that when the real rate is less than inflation, there's something going on. – JTP - Apologise to Monica Nov 16 '15 at 15:22
  • I went back and checked. The deduction would be limited to $15,000 in this case (pub. 936, section on home equity debt). However, this calculation still comes up when trying to figure whether or not to pay off an existing mortgage. It might also work to buy a new home and take out a mortgage despite having cash in hand (but as the rule is primary residence only you'd have to move into it). By the letter it does work but the IRS might find a way to invalidate it. – Joshua Nov 16 '15 at 16:15
  • I'm unaware of the $15K number, my comment was regarding the fact that you can't deduct a loan to buy tax free bonds. Regardless of dollar amount. I'll look at Pub 936 later – JTP - Apologise to Monica Nov 16 '15 at 18:49
  • The $15K was the result of a convoluted example. In the example, that was the amount of loan not interest that one may consider. Please go back to that publication and re-read that section. (Kudos for knowing what pub has the details we all need) – JTP - Apologise to Monica Nov 16 '15 at 22:19
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The likely reason the mortgage is "tricky to get" is the adviser is probably recommending an interest-only mortgage in which there is no repayment of principle before maturity. That would allow you to deduct the amount of the interest expense from your taxable income. Your investment grows compound tax deferred and the principal invested (the mortgage balance) is completely tax free since it never qualifies as income for tax purposes.

Example ideal scenario:

Refinance $100,000 on a 5/1 ARM-interest only at 3%. Invest the $100,000 at 6%. Each year you effectively pay taxes on only the gains greater than interest. If you reinvest the profits it looks something like:

Year    Principal   Gain    Interest    Tax
0       100,000    6,000    3,000       750
1       102,250    6,135    3,000       784
2       104,601    6,276    3,000       819
3       107,058    6,423    3,000       856
4       109,626    6,578    3,000       894
5       112,309    6,739    3,000       935
         12,309   38,151    Taxes paid  5,038

Net Profit: $12,309

Effective Tax Rate: 13.21%

1

This answer is based on Australian tax, which is significantly different. I only offer it in case others want to compare situations.

In Australia, a popular tax reduction technique is "Negative Gearing". Borrow from a bank, buy an investment property. If the income frome the new property is not enough to cover interest payments (plus maintenance etc) then the excess each year is a capital loss - which you claim each year, as an offset to your income (ie. pay less tax).

By the time you reach retirement, the idea is to have paid off the mortgage. You then live off the revenue stream in retirement, or sell the property for a (taxed) lump sum.

  • But you have in pay in money every year, to cover the difference between the interest payments and the income. Presumably the amount you can claim back on these is less than 100%. – jwg Nov 16 '15 at 12:45
  • Wow that is a good idea playing the long game. The idea is it needs to run positive after being paid off. – Joshua Nov 16 '15 at 16:17
  • The strangest variation on this I've seen: persons A and B buy houses, then swap [pay each other token rent]. Each was still paying off ONE mortgage, but now each got a tax deduction. It fell apart when person B wanted to sell and move, but was a cosy setup for a while... – Alan Campbell Nov 17 '15 at 12:31
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the mortgage interest deduction alone couldn't make this work, but if you realize less income by living off the mortgage funds, then it could definitely reduce your taxes by much more than the cost of the mortgage interest. particularly, if you are waiting for some future cut-off date (e.g. turning 59.5 and getting access to roth funds, turning 70 and getting social security, simply doing a roth conversion with strategic recharacterization at age 40 and waiting 5 years to get the money out penalty-free, etc.). and that future date could be quite far off if you only use a small fraction of the total mortgage each year. plus, it is fairly reasonable to assume that equity market returns will outpace mortgage rates, especially if you are "rich" and don't need to worry about living on the street even if the market hits unprecedented lows. while i find most financial advisers to be incompetent (most people really...), i wouldn't write this guy off, just because he left out the specific details that made the strategy work for one particular client.

  • Your points are well presented. The OP's quote, the combination of rich, retired, and a fortune in taxes, implies a number of things that contradict some of your position. But, I agree, it's tough to take a soundbyte out of context and intelligently discuss it. – JTP - Apologise to Monica Nov 18 '15 at 19:52
  • everything is relative. i consider everyone making over 35k$ per year "rich" in the global sense (globalrichlist.com). and most americans will pay a "fortune" in taxes over their lifetime (>500k$ in my back of napkin estimate). that said, i admit my answer was more of an outline of the relevant concerns than a recommended strategy for the OP's adviser's rich client's specific scenario (whatever that could possibly be). – james turner Nov 18 '15 at 21:12
  • James, very insightful. Adjectives are meaningless, it's the numbers that will let us provide real answers. A student recently saw me glance at a second phone and said "you must be rich". A business only phone, worth the extra $20/mo to keep separate, I hadn't given the cost any thought. To him, it implied rich. – JTP - Apologise to Monica Nov 18 '15 at 22:40
  • that is a rather amusing tangent. i actually have 2 cell phones because it saves me money. they are both freedompop phones, and i alternate between the 2 every 15 days to stay under the monthly free data limit. of course, it is frugality rather than profligacy which to me implies wealth. but the student probably meant "high income" rather than "rich". it is unfortunate that english does not have a succinct word for that. – james turner Nov 19 '15 at 18:18
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In the Netherlands its cheaper in some cases to have a mortgage then to own a house.
Example:
If you own a house you pay more taxes (because you own something expensive you have to pay "eigendoms belasting" < owners tax).
So if you instead of owning the house, keep the mortgage low and only pay the mortgage interest, the interest will be much lower then the tax you would have to pay.

The sweet spot (for lowest interest and not having to pay the owners tax) is different for any mortgage but by grandparents use this method and they pay a really small amount for a rather large house.

  • This is wrong, it's the other way around -- if you don't pay interest on a mortage, then you get back all this tax (which is called "eigenwoningforfait", not "eigendoms belasting"). Source belastingdienst.nl/wps/wcm/connect/bldcontentnl/belastingdienst/… – RemcoGerlich Nov 17 '15 at 12:59
  • There is sort of a way with a "bankspaarhypotheek" (a construct that is not allowed anymore for new mortgages), where you would have a mortgage and an accompanying, wealth-tax-free savings account at the same bank with the same rate to pay off the mortgage. You pay interest on the mortgage, get income tax back because of it, and once you have enough money in the savings account, you get more interest there than the net you paid. But that only works once there is enough in the savings account, and putting money in that is restricted. So there's a window of a few years where it makes you money. – RemcoGerlich Nov 17 '15 at 13:07
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yes. you can take out 500,000 form your paid of house. you pay back 500,000 at 3.5. percent. you do get a tax break for not owning your house. it is less then 3.5 you are paying back the back. about one forth of that, BUT you take the 500,000 in invest. Now cd low 1 percent, stock is risky. You can do REIT, with are about 8 to 12 every year. so even at 8 - tax 1.5 is 6.5 - 3.5 bank loan. that 3 percent on your 500,000 thousand, plus tax break, but that only at 8 percent. or 500,000 and buy a apartment building, again about 7 to 10 percent, so that 2 to 3 percent profit, but the building goes up over years.

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