Paying off Mortgages before Retirement

By Erwin Bosman - Imported from 500px (archived version) by the Archive Team. (detail page), CC0, https://commons.wikimedia.org/w/index.php?curid=71327793

I was quoted in Should You Pay off Your Mortgage before Retirement? It opens,

Getting rid of what may be your largest monthly expense and unburdening yourself of debt are great benefits of becoming mortgage free at any age. But it may be particularly attractive as you approach retirement.

“Back in the 20th century, people used to burn their mortgage documents once they had paid the loan off,” said David Reiss, a law professor who specializes in real estate and consumer financial services at Brooklyn Law School in New York. “That practice reflected the freedom that many felt from no longer having to borrow to own their family home.”

Indeed, that emotional freedom helped make the idea of paying off your mortgage before retirement conventional wisdom for financial planning.

And there are still good reasons to consider it.

“It’s always helpful to pay attention to rules of thumb like, ‘You should pay off your mortgage before retirement,’” said Reiss. Those rules are often true under typical circumstances. But you want to understand the assumptions behind the rules and see how they compare with your situation.

Traditionally, the main reasons to pay off your mortgage before retirement are to get rid of the monthly payment (perhaps allowing for a better balance of income with expenses) and to gain the emotional benefit of having your home paid off, said Casey Fleming, a California-based mortgage advisor and the author of Buying and Financing Your New Home.

But there can be other considerations as well. These can include:

Each of these areas can provide good reasons to sunset a mortgage, but also good reasons not to. It all depends on personal circumstances, so it’s important to take a closer look.

Balancing income and expenses

For some people, retirement means shifting to a fixed income that may be lower than what they brought in during their working years. Eliminating a significant bill ahead of time — like a mortgage payment — may make living on a fixed income a little more affordable.

But that may not be the case for everyone.

“For instance, most people see a significant drop in income when they retire,” Reiss said. “If that is not the case for you — you have a great pension, your spouse is still working, etc. — then you have more flexibility when it comes to your mortgage.”

When matching income and expenses in retirement, it’s important also to take a long-term view. For example, if your spouse will retire a few years after you do, you may want to increase your mortgage payments to time their retirement with your loan payoff date.

Emotional benefits

When you carry a mortgage, someone else has a powerful legal hold on your home. Forget to pay your homeowner’s insurance bill? Your lender can buy coverage — very expensive coverage — on your behalf. Miss too many loan payments? Your lender can foreclose.

As noted earlier, taking back that power made paying off the mortgage a celebratory event. Not only did people burn mortgage documents, but some also hung eagles over their doorways, using the symbol of American freedom to herald their freedom from mortgage debt to visitors.

Yet you’re never truly free of foreclosure risk — you’ll still have to pay your property taxes even after you’ve extinguished your mortgage. And most people should still carry homeowner’s insurance, even when a lender doesn’t require it — which means you’ll have to answer to your insurance carrier. If they don’t like the wood-burning stove in your garage, you’ll have to take it out unless you can find another company that approves having it.

Still, many people feel differently about their homes once the mortgage is paid in full.

Liquidity

Paying off your mortgage before you retire — assuming that you’re not already on schedule to do so — means using assets you might otherwise allocate elsewhere.

Generally, if you have enough money in your retirement fund to handle your living expenses comfortably, plus a cushion for extraordinary expenses (like medical bills as you get older), then it’s safe to pay off your mortgage, Fleming said.

But it may be unwise to use liquid assets, such as stocks, bonds, and cash, to pay down your mortgage as you approach retirement because home equity is far less liquid. If, after you retire, you wish you had that money back, you may have to look at options for selling your home, refinancing it, or getting a reverse mortgage, all of which require time and fees.

Return on investment

Paying off any sort of debt gives you a guaranteed return on investment. If you’re carrying a mortgage at 7 percent, paying it off may be attractive because you typically would have difficulty earning a guaranteed 7 percent long term anywhere else.

Of course, with a lower mortgage rate or a higher risk tolerance, early mortgage repayment becomes less attractive from an ROI perspective. So, it becomes a personal choice about risk and lifestyle.

Taxes

Another argument in favor of paying off your mortgage before retirement is if you won’t lose a tax deduction by doing so.

“The standard deduction is pretty high now, and many seniors don’t benefit anymore from the mortgage interest tax deduction,” Fleming said.

If your standard deduction is greater than your itemized deductions — and for the vast majority of Americans, it is — you can’t reduce your tax obligations by deducting your mortgage interest.

However, the standard deduction in effect today could halve in 2026. The doubling of the standard deduction that became effective in 2018 is one of many tax code provisions that’s set to expire at the end of 2025.

And even if your mortgage interest by itself doesn’t get you over the standard deduction threshold — in 2023, that’s $13,850 for single taxpayers, $27,700 for married taxpayers who file jointly, and $20,800 for heads of household — when combined with other itemizable deductions such as charitable donations and state and local income taxes, paying off your mortgage early might increase your tax bill.

“If you pay off a mortgage early, you are saving on mortgage interest, but you may also be giving up the mortgage interest deduction,” Reiss said. “If you do not pay it off early, you can earn interest in a bank account, but you will be paying taxes on that interest. You want to think through the consequences of your choice to see which is the most financially attractive, including the tax consequences.”

The Impact of Tax Reform on The Real Estate Sector

photo by Sergiu Bacioiu

Congress passed the tax reform act on December 20, 2017 and President Trump is supposed to sign it by the end of the week. A lot of ink has been spilled on the impact of tax reform on homeowners, but less on real estate as an investment class. It will take lawyers and accountants a long time to understand all of the in ands outs of the law, but it is pretty clear that commercial real estate investors will benefit significantly. Most of the provisions of the act are effective at the start of the new year.

Homeowners and the businesses that operate in the residential real estate sector will be impacted in various ways (the net effect on any given taxpayer will vary significantly based on a whole lot of factors) by the increase in the standard deduction; the limits on the deductibility of state and local taxes; the shrinking of the mortgage interest deduction; and the restrictions on the capital gains exclusion for the sale of a primary residence. There are tons of articles out there on these subjects.

The impact on real estate investors has not been covered very much at all. The changes are very technical, but very beneficial to real estate investors. There are a couple of useful resources out there for those who want an overview of these changes. The BakerBotts law firm has posted Tax Reform Act – Impact on Real Estate Industry and the Seyfarth Shaw law firm has posted Tax Reform for REITs and Real Estate Businesses.

To understand the impacts on the real estate industry in particular, it is important to understand the big picture.  The new law lowered the highest marginal tax rates for individuals from 39.6% to 37% (some individuals will also need to pay unearned income Medicare tax as well). The highest marginal tax rate applicable to long-term capital gains stays at 20% for individuals. The other big change was a reduction in the corporate tax rate to 21%. Because qualified dividends are taxed at 20%, the effective tax rate on income from a C corp that is distributed to its shareholders will be 36.8% (plus Medicare tax, if applicable).

Benefits in the new law that particularly impact the real estate sector include:

  • REITs and other pass-through entities are eligible for as much as a 20% deduction for qualified business income;
  • favored treatment of interest expense deductions compared to other businesses;
  • Real estate owners can still engage in tax-favored 1031 exchanges while owners of other assets cannot; and
  • Some types of commercial real estate benefit from more favorable depreciation provisions.

While it is clear that real estate investors came out ahead with the new tax law, it is not yet clear the extent to which that is the case.

The Impact of Tax Reform on Real Estate

Cushman & Wakefield have posted The Great Tax Race: How the World’s Fastest Tax Reform Package Could Impact Commercial Real Estate. There is a lot of interesting insights in the report, notwithstanding the fact that ultimate fate of the Republicans’ tax reform is still a bit up in the air. Indeed, C&W estimates that there is a 1 in 5 chance that a bill will not pass this year.

Commercial Real Estate

C&W states that history

suggests that tax law changes by themselves are often not key drivers for transactions or for investment performance. However, there is likely to be a period of transition and market flux as investors restructure to optimize tax outcomes with implications for the underlying asset classes. Corporations are likely to separate the real estate aspects of their businesses. (2)

The commercial real estate industry is largely exempt from the biggest changes contained in the House and Senate bills. 1031 exchanges, for instance, have not been touched. C&W sees corporations being big beneficiaries, with a net tax cut of $400 billion over the next 10 years; however, they “anticipate that the tax cut will be preferentially used to return capital to shareholders or reduce debt, rather than to increase corporate spending.” (2)

Residential Real Estate

C&W sees a different effect in the residential real estate sector, with a short-term drag on home values in areas with high SALT (state and local tax) deductions, including California, NY and NJ:

The drag on home values is likely to be largest in areas with high property taxes and medium-to-high home values. There is also likely to be a larger impact in parts of the country where incomes are higher and where a disproportionate proportion of taxpayers itemize. Both versions of the tax reform limit property tax deductibility to $10,000. While only 9.2% of households nationally report property taxes above this threshold, this figure rises to as high as 46% in Long Island, 34% in Newark and 20% in San Francisco according to Trulia data.

The Mortgage Bankers Association (MBA) estimates that 22% of mortgages in the U.S. have balances over $500,000, with most of these concentrated in high costs areas such as Washington, DC and Hawaii—where more than 40% of home purchase loans originated last year exceeded $500,000. This is followed by California at 27%, and New York and Massachusetts at 16%. (6)

C&W also evaluated tax reform’s impact on housing market liquidity and buy v. rent economics:

The median length of time people had owned their homes was 8.7 years in 2016—more than double what it had been 10 years earlier. Now that interest rates have begun to tick upward from their historic lows, the housing market may face a problem called the “lock-in” effect, where homeowners are reluctant to move, since moving might entail taking out a new mortgage at a higher rate. This leads to the possibility of decreasing housing market liquidity in high-priced markets.

All things considered, the doubling of the standard deduction and the cap on the property tax deduction is likely to have the largest impact on the buy vs. rent incentive, especially as it seems likely that there will be minimal changes to the mortgage interest deduction in any final tax reform bill. (7-8)

Republicans and the Mortgage Interest Deduction

photo by Nick Youngson

There is a lot to hate in the Republican tax reform plan contained in the proposed Tax Cuts and Jobs Act. (click here for a summary and here for the text of the bill itself). Overall, the bill is extraordinarily regressive, heavily favoring the wealthy. There will, of course, be all sorts of compromises to this proposal as Republicans work to get it passed. But it is worth highlighting what is good about the bill as it would be a shame to lose sight of it while the sausage is being made in Congress.

The best real-estate related provision from a policy perspective is the reduction of the mortgage interest deduction. In a section of the summary with the Orwellian title, Preserving the Mortgage Interest Deduction, the Republicans outline how they will slice the deduction in half:

For so many Americans, buying a home is often the largest investment – and perhaps most important – investment they will make in their lifetime.

The Tax Cuts and Jobs Act will continue to support the American dream of homeownership by preserving the Mortgage Interest Deduction.

This ensures that hardworking families can continue to access this important tax relief as they buy, own, and maintain their home.

Policy Specifics

• Increasing the standard deduction means a simpler, fairer, and flatter tax code in which fewer taxpayers need to go through the trouble of determining whether they should itemize.

• Under the Tax Cuts and Jobs Act, taxpayers will still be able to deduct mortgage interest in excess of the standard deduction, in combination with other remaining itemized deductions, including charitable contributions and property taxes.

• The mortgage interest deduction would be available for interest paid on new mortgages for up to $500,000 in home acquisition indebtedness on principal residences.

• For existing mortgages, the plan allows for current law deduction on indebtedness of up to $1,000,000 and up to $100,000 in home equity to help taxpayers who may have relied on the current mortgage-interest deduction.

How This Policy Helps the American People

Preserving the home mortgage – and the deduction for state and local property taxes – will help more Americans of all income levels achieve the American dream of homeownership. (15-16)

This plan would cut the principal amount of a mortgage that would be eligible for the mortgage interest deduction from the current maximum of $1,000,000 to $500,000. Given that wealthy households generally take the mortgage interest deduction more often and get more bang for their buck from it, it is a regressive aspect of the tax code.

It is striking that a provision with such broad support such as the mortgage interest deduction is actually on the table. It will be interesting to see how special interests in the real estate industry will respond. My bet is that at the end of day the deduction will remain mostly untouched, even though this particular Republican proposal makes good policy sense.