Deciding If Refinancing Is Beneficial – Part 3
Deciding If Refinancing Is Beneficial – Part 3
In Part 1 of this series we covered some basic issues regarding the decision of whether or not to refinance a property. In Part 2 we considered the basic principles related to determining how long it takes for the reduced interest rate to repay the costs of refinancing. We ended Part 2 by mentioning that when analyzing the benefit of a lower rate loan must consider the after-tax numbers rather than only the amount of interest included in your payment. To varying degrees, other loan costs must also be analyzed for tax affects.
In fact, you must consider that if not regularly in the zero marginal tax bracket you may even pay more income tax after refinancing at a lower rate, at least in some years. In review, the marginal tax bracket is the percentage of taxable income you will pay if you have more in income or less in deductions than expected. The marginal federal tax rates in 2013 ranged from 0 percent for taxable income of less than $18,150 to a maximum 39.6 percent for taxable income higher than $457,600. For examples in this article we’ll assume a marginal federal tax rate of 25 percent with taxable income between $73,800 and $148,850. State income tax rates vary from zero for states having no income tax to around 9 percent in states having the highest maximum rates. Municipal income tax rates for those cities taxing income vary from a fraction of a percent to around 3 percent in some of the higher rate cities. Although landlords often have lower taxable income than the typical taxpayer because of depreciation, for the examples in this article we’ll assume a total (federal + state + local income taxes) marginal rate of 30 percent.
Refinancing can result in a higher income tax because you are paying less annual interest on the new loan than you were paying on the old loan, resulting in a smaller expense deduction. The impact of this fact depends on many variables including the difference in interest rates between the old and new loan, whether or not the old and new loans had equal amortization lengths, the percentage of the amortization term that has passed since the old loan began, and, and of course, your marginal tax rate. Accordingly, the after-tax interest savings is reduced by the tax on the interest savings on the new loan at its beginning compared to the interest on the old loan at the time of refinancing. While refinancing is usually beneficial in the long term, it is entirely possible to have little benefit in the short term taking into consideration the time spent on obtaining the new loan, even experiencing a net loss in the early years after refinancing.
As an example, we’ll assume that you are refinancing a loan that has a current balance of $200,000 and, due to the current financing market conditions, rates have dropped in the interim resulting in a new rate for a fixed rate 30-year long that is 2.0 percent lower than the rate of the old loan. We’ll also assume that the old higher rate 30-year loan was obtained relatively few years before, meaning that the amount of principal pay-down is small relative to the size of the loan, and we will be refinancing approximately the amount of the old loan principal balance. Also, although the refinance could have been done at any time during the tax year, meaning that the interest savings for the year of refinance might be less than a full year’s amount, for simplicity we’ll assume that the loan closed at the very beginning of the year resulting in a full year of interest savings.
These assumptions provide an interest savings of approximately $4,000 in the first year, ignoring that the amount of interest drops a little for each monthly payment. This translates into an additional $1,200 in income tax, leaving $2,800 of the first year interest savings to apply against the refinance costs.
Now, one might expect that we will receive a significant income tax savings in the first year from deducting the refinance costs. However, the tax code reduces the benefit because some of the costs that you pay up-front to refinance are not fully deductible on your first year’s income tax return, but must be amortized over the life of the 30-year loan. Escrow fees, appraisal fees, and title insurance premiums are in this category, as are certain other types of loan related costs. This means that, although your reduction in interest costs are essentially taxed fully as the benefit is received, you can only expense 1/30th of many refinance costs each year even though you paid them all at the closing of your new loan. There could also be costs that are not related to the loan term and must be spread over the depreciation life of the property – 27.5 years for residential property or 39 years for commercial. An example of this last issue would be if the lender required correction of some deferred maintenance, with the cost likely being deductible, but only as additional depreciation.
Continuing with our example, we’ll assume that you’re paying a 2 points loan fee, not an unusual fee for rental properties. We’ll further assume that the total fee is fully deductible because of what it’s called by the lender and it meets the then-current IRS rules, not always the case. This should result in a deductible amount for loan points of $4,000 (2 percent of $200,000). We’ll assume that all other costs of refinancing – including appraisal, lender title insurance, and escrow fee – totaling $3,000 must be amortized over 30 years ($100 per year). So, ignoring the value of the time spent for refinancing, you have a total refinancing cost of $7,000.
Thus, from the refinance costs, we have a tax deduction of $4,100 ($4,000+$100) for the year of refinancing, but a deduction of only $100 for each year thereafter. With the net interest saving from being in our 30 percent tax bracket, the first year deduction of refinancing costs results in a tax savings of $1,230 (0.3X$4,100). Thus, the total amount of interest that can be applied against the costs of refinancing for the first year is $2,870 ($4,100-$1,230), leaving a balance of $4,130 ($7,000 – $2,870) to be recovered in subsequent years.
For the second and subsequent calendar years, ignoring the changes in interest as the loan amortizes – reasonable for the first years of the new loan – we’ll have $100 being deductible from refinance costs, producing a tax savings of $30. Adding this to the $2,280 net (after-tax) savings from our lower interest rate gives an amount of $2,310 to apply against the costs of refinancing in subsequent years. Thus, applying that amount against the $4,130 balance of refinancing costs remaining after the second year leaves $1,820 ($4,130-$2,310) to be paid off in the third year. It would require approximately 8 months of the third year to pay the balance.
For our example, it required approximately 2-2/3 years for the savings to pay the costs of refinancing. How long it requires for your refinancing will depend on all the variables for which we made assumptions in our example and on others possible variables not considered. The time required could be somewhat shorter or significantly longer, depending on the numbers. Note that refinancing at other than the beginning of the year, as we assumed, would not have changed the fact that approximately 32 months would be required. Of course, depending on the month when the new loan replaced the old one, it might require spreading our recapture of costs over 4 tax years rather the 3 for our example where we assumed the refinance occurred at the beginning of the year.
For the case of your marginal tax bracket being zero, the time for recapture of financing costs is simply the costs divided by the interest savings – $7,000 divided by $4,000, or 1-3/4 years. At the other extreme of the highest possible marginal tax bracket, the time for recapture of financing costs would be greater than for the 30 percent bracket of our example. As expected, taxation has ramifications for the refinance issue, just as it does with all other aspects of life.
An analysis that provides accurate results becomes significantly more complex when the loan being refinanced is older, the difference in interest rates is smaller, amortization periods are different, one or both old and new loans have variable interest rates, the borrower has marginal tax rates that change year-to-year, and other factors.
In Part 4 of this series we will look at some other issues regarding refinancing that can further complicate making the decision of whether or not to refinance.