Cash Purchase Pros and Cons: Tax and Financial Planning Strategies

Paying cash for a property can give a buyer a huge strategic advantage. But it can come at significant opportunity cost, and carry financial downside depending on the circumstances. Just as a financial advisor will carefully select asset allocations across different market sectors, the amount of equity tied up in real estate needs to be considered when looking at a client's overall net worth. 

People pay cash for a variety of reasons, but the primary one we hear is "I don't want to have any debt" or "I don't want a mortgage on my house". However, tying up large amounts of cash in a property (or leaving equity in a highly appreciated property) may mean missed opportunity to invest that equity in better-performing or more readily accessible investments. 

Real estate appreciates at the same rate, whether or not it is financed. Using mortgage debt strategically to balance the amount of equity tied up in the property, with the benefit of liquidity in an investment account that is growing in parallel, provides the security of readily available liquidity and the tax benefit some mortgage debt is eligible for.

Benefits of purchasing a property with cash:

Strategic advantage: Cash buyers almost always rise to the top of a pile of offers, because these transactions can close simply and quickly. In some scenarios including tax-sale foreclosures and probate, cash may be quickest way to successfully close unless a private money lender is on standby to fund these purchases.

Financial advantage: Cash buyers may be able to negotiate a lower purchase price compared to a buyer using a traditional mortgage, because sellers and listing agents often perceive a cash offer as a more certain, simpler transaction.

Timing advantage: Cash purchases can close as quickly as 5-7 days. In time-sensitive conditions, this may be powerful motivation for a seller to accept an offer.

Disadvantage of paying cash for a property:

Loss of Primary Residence Mortgage Interest Deduction: On a primary residence, mortgage interest on the first $750,000 of mortgage acquisition debt is a valuable tax deduction. The IRS rules dictate that this debt must be taken out within 90 days of the purchase. 

Opportunity Cost: Cash tied up in real estate is not readily available for other opportunities, either to acquire more real estate, make improvements which may increase the property value, or keep this cash invested in assets that are either gaining value, earning dividends, or on standby to take advantage of other opportunities. Once equity is tied up in real estate, it can only be accessed through sale or refinance of the property--both of which can take time, expense, and effort to complete.

Risk Management: In case of a disaster like fire, landslide, or flood, having cash tied up in a property may result in loss of equity that exceeds the post-disaster value of the home. A luxury home in a wooded area may be worth far more than a rebuilt version of exactly the same home, on a scorched and barren plot of land. Carrying debt on a property can be a way to strategically manage this risk, as long as the home is adequately insured. In case of a total loss, insurance proceeds can be used to pay off any mortgage balance, and the remainder can be used to purchase a new home in a different area. In circumstances where homeowner insurance may not cover losses (such as landslide, force majeure, acts of war, cancelled policy, or other excluded risks), some owners may opt to walk away from the home in the event of a disaster, effectively sharing the loss with the mortgage lender. 

How to use mortgage debt strategically, for tax efficiency and liquidity

Primary residence refinance (delayed financing) within 90 days for $750,000 mortgage debt deductibility: A cash out refinance within 90 days of purchase can allow a buyer to recoup a large part of the cash purchase price, with rates and guidelines the same as a regular purchase loan, while securing the purchase acquisition mortgage debt that is eligible for the mortgage interest tax deduction. The net cost of this debt, after tax benefit, may be lower than the returns on the recouped cash, if the proceeds of the refinance are reinvested efficiently. For instance, if mortgage interest is 6% per year, but offsets earned income for a homebuyer in a 30% tax bracket, the effective rate of the mortgage debt is also reduced by this 30%. In this instance, the effective rate after tax benefit, would be 4.2%. So the cash replaced by this mortgage debt would only need to grow by 4.2% to break even on this equation. 

Post-purchase refinance to recoup cash: Even if mortgage debt above and beyond the $750,000 threshold is taken out, this cash can be re-invested or held for future use in cash or bonds. This may be especially important for clients approaching retirement within a few years, as refinancing to pull cash out can become more challenging after retirement, when earned income is no longer available for mortgage qualification.

Reverse 1031 exchange: Private money or NonQM loans (DSCR rental cash flow loan) can be use to purchase a replacement investment property, prior to selling the property to be relinquished. Private money cross collateral loans use the value of the new property and a second property to maximize leverage, and can sometimes make it possible to purchase a new property with no downpayment. The upfront cost of the private money may far exceed potential tax liability incurred if a highly appreciated property is sold with the intention to exchange, but the seller is unable to secure and close a replacement property purchase within the prescribed timeframes (45 days to identify and 180 days to complete the replacement property purchase). 

BRRRR strategy: Many investors follow the buy, renovate, rent, refinance, repeat strategy. Use cash or private money/cross collateral loans for acquisition, and replace with longer term financing once purchased and/or renovated. Smart investors may also opt to "harvest equity" by completing a cash out refinance on these properties, and using the cash to purchase additional rental properties. Mortgage interest on investment properties may be used to offset rental income to reduce taxable income on investment properties, and re-deployed to continue building an investor's portfolio. Rental properties can be purchased or refinanced using DSCR (rental cash flow loans), with NO personal income--the rental income from the subject property is the only income necessary to qualify. Use a refinance to pull out cash for a downpayment on a second property, and finance the remainder of the new property with the same type of loan. 

* refer to the IRS website for current tax information, or consult your CPA, financial advisor, attorney or tax preparer for additional information. The information included in this article is meant to prompt discussion and is not meant to be a substitute for the advice of a licensed, experienced legal, tax, or financial professional.