When it comes to positive cash flow properties, what should you do with your passive income?
Now before you answer that question…
Or think to yourself, “Hmmm, Dymphna must be losing her mind; everybody knows to use the passive income to buy another cash cow…”
Let me explain what I mean…
Yes, I’m a big believer in passive income! No surprise in that, is there?
And yes, you know that each property you buy should set you up for the next one (see my previous e-letter about that).
Taxes eat into your profits!
But when you look at your total financial picture, you also see that the amount of tax you pay on your total income directly affects your profits, doesn’t it?
So let’s look at a typical situation to see how you can use your cash cow to reduce your tax burden and still set you up for your next property deal…
Congratulations! You’ve just made a great deal on a cash cow. (Remember, you make your money on the purchase of the property, not on the sale price, so look carefully at each deal before you buy.)
Say you were able to buy the rental property for 15- 20 percent under market value and the passive income is steady each week. (Also keep in mind that your passive income is that income left over after all expenses are paid, including interest, insurances, council fees, management costs and repairs.)
Great! You’re well on your way with that property. But with that extra money coming in, you’re going to need an offset to it, aren’t you?
Fortunately, the interest payments on the money you borrowed to buy that cash cow are tax deductible as well!
That’s why tax-deductible interest on your investment loan is called “good debt;” it is at least a partial tax offset to your positive cash flow income.
Now, when you think of it that way, it makes sense to hold only good debt and get rid as much of your “bad debt” as you can…
What do I mean by bad debt?
Well, for one, the interest you’re paying on your mortgage loan for your PPR is NOT tax deductible…
So that is considered bad debt. You have to pay it, of course, but you can’t offset any income gains with it.
The same rules of bad debt apply to most credit card debt. You have to pay the interest and principle, but you can’t write it off – unless, of course, those expenses are business related.
Trade bad debt for good debt…
So what does this bad debt –especially on your PPR– have to do with your passive income cash cow?
Well, suppose you’re still working, still collecting a paycheck from your regular job and you’ve just bought that cash cow we were talking about…
So now you’ve just given yourself a raise with that passive income coming in, haven’t you?
Guess what? You’re going to pay more tax, aren’t you?
Now I don’t view paying tax on that extra income as a problem or necessarily bad. When you think about it, you’re only paying taxes if you’re making money, right?
But on the other hand, there’s absolutely no need to pay more tax than you really have to, is there?
So, from a good debt-bad, debt perspective, it makes sense to trade in your bad debt for good debt. How do you do that?
Pay down your PPR mortgage
One very easy way to do that is to use the passive income you’re now getting from your cash cow to pay down your mortgage on your PPR!
But wait? Shouldn’t you be buying another cash cow from that income?
Yes you should. But if you are making payments on a PPR mortgage, you want to minimize that bad debt so you can offset the higher taxes you’ll be paying.
Therefore, as you pay down that mortgage on your PPR over the next several months, you can then re-borrow from the higher equity you’ve gained in your PPR to buy another cash cow.
That way, you are turning your bad, non-tax-deductible PPR mortgage debt into tax-deductible, real estate investment debt, which is good debt.
Also, you’ve now taken money from your PPR, which you’re paying about five percent-ish on it, and using it to buy a cash cow which is yielding you 8-10 percent-ish…
I say “ish” because interest rates go up and down daily and the yield on any given cash cow will be different from one to the next.
Use interest-only loans
And by the way, I recommend that you get interest-only loans on your properties, and that includes your PPR and cash cows.
There are some very good reasons for this. For one, paying an amortized loan is a very slow way to build equity. For another, so is waiting for the market to rise.
I prefer to manufacture equity by improving the property in various ways. Plus, the principal payments in an amortized loan are not tax deductible, only the interest payments are.
I realize, of course, that this scenario may not apply to everyone. If you’re well on your way down the track with a large portfolio of properties, then you’ve already got this part sorted out, haven’t you?
Or, if you’ve sold your PPR to get into real estate investing, then you’ve already got rid of your bad debt, so good on you!
But when you’re on that first or second property and you can see the taxman coming up the road with your new passive income on his mind, you want to have an answer that makes sense.
Good debt can literally protect you from paying more tax than you need to and help you keep more of your income in your pocket…right where it belongs!