After weeks of digging, you find a home run deal for a new rental property to add to your portfolio. The asking price fits within your budget, the numbers work, and the cash flow is exactly what you’re looking for.
There’s only one problem… You need cash to fund the purchase.
You may be looking for capital to use as a down payment and plan to finance the rest with a bank or other lender. Alternatively, you may not want to use outside leverage and prefer to buy the investment property with all cash, which isn’t always the best move.
Without a network of private lenders or a rich uncle, how can you get your hands on some money?!
What if you already have access to the cash but don’t know where to look for it?
No, I’m not telling you to grab a shovel and dig up the millions of dollars buried in your backyard (if you do happen to find some buried treasure, though, I expect a finder’s fee for making you look in the first place).
Here are three ways to access cash you never even knew you had, completely tax-free.
1. Home Equity Line of Credit (HELOC)
A HELOC is a revolving loan that is secured by your property. Think of it as a credit card; you have a limit on how much you can borrow (based on your equity in the property) and payments aren’t due/interest isn’t charged until you actually draw money from it.
Payment terms with respect to HELOCs can be structured as interest-only for a predefined period. Typically, interest rates are variable and the terms usually involve a draw period (the window of time in which you can access the funds, commonly 10 years) and a repayment period (how long you have to repay what you borrowed, commonly 15-20 years).
The advantages of a HELOC are that you can borrow only what you need when you need it, and that interest rates are currently very low.
Disadvantages include possible increased repayment amounts due to the rising interest rates (which is the case right now) and ongoing maintenance or annual fees.
2. Home Equity Loan (HEL)
A HEL is similar to a HELOC in that the loan is secured by and determined based on the equity in your property but the difference is that a HEL lets you borrow a lump sum to be repaid over a fixed period of time. Think of it as a second mortgage.
The main advantage of a HEL compared to a HELOC is that the interest rate can be fixed and your payments would then be consistent throughout the entire term of the loan.
Disadvantages include the inability to borrow as you need it (you get one sum of money all at once) and potentially higher closing costs than those of a HELOC.
3. Cash-Out Refinance
A cash-out refinance is essentially a replacement loan for your current mortgage. This is usually done as either the property value increases or the balance of your existing loan decreases.
I know what you may be thinking… If the loan is a replacement, how will I get any cash out of this?
The amount of the refinanced loan would exceed the amount of the current mortgage. For example, if you owe $50,000 on your existing loan and refinance for $125,000, you repay the $50,000 and have $75,000 of cash at your disposal.
Advantages of a cash-out refinance include having only one form of debt against the property and lower interest rates (on average) than those of a HELOC or HEL.
Disadvantages include possibly incurring private mortgage insurance (PMI) if you leverage more than 80% of the home’s value and unintentionally raising the interest rate on your debt if you refinance at a time where the economy supports higher rates or with a lender who charges higher rates. Be mindful of the terms of your current mortgage before refinancing.
Common Denominators
Each of the three methods above involves tapping into the equity of your existing investments. Without equity in your personal residence or rental properties, you will be unable to use the above methods to access funds.
Also, each lender offers different terms, rates, and options. Certain lenders may offer a higher loan-to-value (LTV) than others and some may require lower debt-to-income (DTI) ratios than others.
Be sure to shop around when looking for a HELOC, HEL, or cash-out refinance. Come up with a list of questions to ask each lender and see what works best for you.
You should also check in with your CPA to see which option would yield the most tax benefits to you.
Tax Implications
By leveraging your own portfolio, you are able to draw out a lump sum of cash without triggering a taxable event.
The benefit is twofold:
- Tax-free receipt of cash
- Deductibility of interest paid on the HELOC, HEL, or cash-out refinance. This is circumstantial; check with your CPA to make sure you can deduct the interest payments.
Accessing cash from the equity in your rental properties allows you to scale your portfolio without generating a substantial, unwanted tax bill. Hopefully, you won’t even be the one paying back the loan; if the cash flow on your properties can cover the additional debt service, you can thank your tenants for buying you a new investment property.
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Aiola CPA, PLLC is a 100% virtual CPA firm, specializing in tax planning and preparation for real estate investors. See more at www.aiolacpa.com
