I have a couple properties and was looking to make extra principal payments on them to pay them off before I retire. Retirement is about 15 years away and would like them paid off to supplement my pension. Making extra payments, what are the tax consequences of extra payments? Are they excluded from the capital gains taxes?
Thanks in advance
Your capital gain on sale of the property is determined by your cost basis and the sale proceeds. Cost basis is equal to your purchase price plus the cost of capital improvements and minus depreciation. The presence or absence of financing does not affect the capital gain calculation. While there is no direct tax consequence from making extra principal payments, there is an indirect consequence.
Making extra principal payments does reduce your annual interest payments. Since loan interest is a Schedule E expense, paying off your loan balance will eventually eliminate the mortgage interest deduction on your Schedule E.
Is the extra principal payments considered capital improvements? or will I be taxed again on this money when I go to sell it? double taxation on revenue every year and when I sell it?
Buy a property for $100K, your cost basis is $100K. Sell the property for $120K, your sale profit (your capital gain) is $20K (sale price minus cost basis). Cost basis is determined by how much you PAID for the property, not by how much you had to borrow to buy the property.
It does not matter whether you have a loan balance on this property, or own the property free and clear, your taxable profit (sale price minus purchase price) in this example is still $20K. As I said earlier, your loan balance is not used to determine your capital gain. Hence, there is no direct tax impact to paying extra principal to retire a loan. Paying off a loan does not change how much profit you make on the sale of the property.
For the $100K property in this example, capital improvements are the things you do to increase the value of the property or extend its useful life. For example, spending $25000 to add on a room, adds value to the property. That $25000 is a capital improvement that increases your cost basis from $100K to $125K. Another example: spend $13000 to replace the 20 year old roof on this $100K property. You have extended the useful life of the property and increased your cost basis from $100K to $113K.
No, principle payments early are not capital improvements - capital improvements are those which you spent money to “improve” the property.
The only consequence I see of paying principle early is you have less cash in your pocket, tenants pay for everything, I won’t pay a penny more toward loans if I don’t have to, ya know?