Is Paying Debt An Operating Expense

In The Complete Guide to Investing in Rental Properties (New York: McGraw-Hill, 2004), I described the use of debt in the following excerpt.

Table 5.2 Effect of Leverage on Invested Capital Applying Annual Appreciation Only

Purchase Price: $500,000

Percent Down: 15.0%

Down Payment: $75,000

Purchase Price: $500,000

Percent Down: 15.0%

Down Payment: $75,000

Number of Years

Annual Appreciation Rate

5.0%

Ret on Inv

10.0%

Ret on Inv

20.0%

Ret on Inv

1

525,000

33.3%

550,000

66.7%

600,000

133.3%

2

551,250

68.3%

605,000

140.0%

720,000

293.3%

3

578,813

105.1%

665,500

220.7%

864,000

485.3%

4

607,753

143.7%

732,050

309.4%

1,036,800

715.7%

5

638,141

184.2%

805,255

407.0%

1,244,160

992.2%

6

670,048

226.7%

885,781

514.4%

1,492,992

1324.0%

7

703,550

271.4%

974,359

632.5%

1,791,590

1722.1%

8

738,728

318.3%

1,071,794

762.4%

2,149,908

2199.9%

9

775,664

367.6%

1,178,974

905.3%

2,579,890

2773.2%

10

814,447

419.3%

1,296,871

1062.5%

3,095,868

3461.2%

11

855,170

473.6%

1,426,558

1235.4%

3,715,042

4286.7%

12

897,928

530.6%

1,569,214

1425.6%

4,458,050

5277.4%

13

942,825

590.4%

1,726,136

1634.8%

5,349,660

6466.2%

14

989,966

653.3%

1,898,749

1865.0%

6,419,592

7892.8%

15

1,039,464

719.3%

2,088,624

2118.2%

7,703,511

9604.7%

16

1,091,437

788.6%

2,297,486

2396.6%

9,244,213

11659.0%

17

1,146,009

861.3%

2,527,235

2703.0%

11,093,056

14124.1%

18

1,203,310

937.7%

2,779,959

3039.9%

13,311,667

17082.2%

19

1,263,475

1018.0%

3,057,955

3410.6%

15,974,000

20632.0%

20

1,326,649

1102.2%

3,363,750

3818.3%

19,168,800

24891.7%

21

1,392,981

1190.6%

3,700,125

4266.8%

23,002,560

30003.4%

22

1,462,630

1283.5%

4,070,137

4760.2%

27,603,072

36137.4%

23

1,535,762

1381.0%

4,477,151

5302.9%

33,123,686

43498.2%

24

1,612,550

1483.4%

4,924,866

5899.8%

39,748,424

52331.2%

25

1,693,177

1590.9%

5,417,353

6556.5%

47,698,108

62930.8%

Other people's money can be provided to you in one of two forms—either debt or equity. The most common type of financing is debt. Debt is most often provided in the form of some type of loan which can come from any number of sources including banks, mortgage companies, family members, friends, credit cards, and home equity loans to name a few. Financing with debt typically requires that you repay a loan with predetermined terms and conditions such as the repayment term (number of years to repay the loan), the interest rate, and any prepayment penalties which may be imposed for paying off a loan early.

One primary advantage of using debt is its lower cost of capital than other forms of financing such as equity. Another advantage of using debt is that it is typically more readily available than equity. One key disadvantage of using debt is that the debt must be serviced. In other words, you have to make periodic payments on the loan. Using debt as a source of financing will usually have a direct negative impact on the cash flow from your rental house since loans usually require monthly payments. It should be obvious to you that the more you borrow for a particular investment, the greater your monthly payment will be, and the greater your monthly payment, the less the property's after tax cash flow will be. As a smart investor, you must be sure that you have structured the purchase of your rental house in such a manner that will allow you to service the debt on it, whatever the source of that debt is, without a negative cash flow. This is after all expenses have been accounted for. You should have a minimum of a 1.1 to 1.2 ratio of free cash flow left over after all expenses have been paid to ensure that you can adequately meet the debt requirements. Debt is a wonderful tool, but like any tool, you must exercise caution and respect when using it. Otherwise you can quickly find yourself in trouble. You must be in control of your debt. Do not allow your debt to control you.

From this excerpt, we learn that the primary advantages of using debt are that it is readily available and that it can typically be obtained at a lower cost than alternative financing sources such as equity. In Chapter 3, we examined the effect of different interest rates on the value and returns of an income-producing property. The lower the cost of funds, the greater the cash flow, and the greater the cash flow, the greater an investor's returns.

We also learned that one key disadvantage is that debt usually requires that some type of periodic payment be made. This is especially important because an investor purchasing a non-income-producing property may have a difficult time making the required periodic payments. For example, when I purchase land on which to build houses, my preference is to defer all interest and tax payments for as long as I can. If possible, I structure the financing in such a manner that no payments are due until a lot is released. When a house is ready to be built on a particular lot, all accrued interest and taxes are paid on the lot at that time. The payment is made from the construction loan used to build the house. Structuring the financing in this manner enables me to lever up without having the burden of making periodic payments on the land.

One additional advantage of using debt is that the interest portion of the payment is tax deductible, because interest is treated as an expense for tax purposes. Since the interest portion of a debt payment is tax deductible, the effective interest rate is lower than it otherwise would be. This provides investors with an added incentive to use debt rather than equity, since they are able to further reduce their cost of funds. Let's take a moment to look at an example to see how this works.

Loan amount = $100,000 Interest rate = 6.50%

Annual interest paid = $100,000 x 6.50% = $6,500 Investor's tax rate = 35% Reduction in taxes = $6,500 x 35% = $2,275 Effective interest rate = ($6,500 - $2,275) = $4,225 + $100,000 = 4.225%

This example assumes a loan amount of $100,000 and cost of funds of 6.50 percent. An investor in a 35 percent tax bracket would realize $2,275 in savings as a result of the reduction in tax liability. The annual cost of funds is reduced from $6,500 to $4,225, which in turn reduces the effective tax rate to 4.225 percent.

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  • deena
    Is paying debt an operating expense?
    19 days ago

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