You Pay Taxes on the Money Used to Pay Off the Mortgage
Assuming that the syndicate buys a building for $900,000. It pays $300,000 in cash and gives a mortgage for $600,000. It agrees to make constant payments on the mortgage at the rate of $60,000 per year. These payments are to be applied first to 6% interest on the balance which may be due on the mortgage. The rest of the payment is used to reduce the amount of the mortgage. During the first year interest on that mortgage amounts to $36,000, that is 6% on $600,000. The rest of the $60,000 payment, that is $24,000 is applied to repay a part of the principal of that mortgage, or if you want to, to reduce the amount of the mortgage. In other words, at the end of the year, the mortgage would be reduced by $24,000 and there would only be $576,000 owing.
Suppose now that after a number of years the balance still due on the mortgage is down to $300,000 and suppose that the agreement to pay $60,000 every year continues. The interest in that year will amount to 6% of $300,000, that is only $18,000. The remaining $42,000 can now be applied to the reduction of the mortgage. The syndicate continues to pay $60,000 every year to the owner of the mortgage. All other things being equal, it continues to have the same sum available for distribution to you and the other investors. But taxwise, there is a difference. The money it pays out for interest is tax free. Interest is a business expense. The money the syndicate pays out to reduce the mortgage indebtedness is not free of taxes. It is really a payment of the syndicate's debt (not an expense). You do not get any tax reduction just for paying your debts.
The position of the syndicate is not much different from your own. If you earn money, you have to pay taxes on these earnings, and the collector does not care whether you use that money to repay your debts or use it for yourself. So in our case, while the payments to be made on the mortgage remain constant at the rate of $60,000 a year, the amount paid out for interest decreases and correspondingly the expenses which you can deduct on your tax return decrease. The amount being paid out for repayment of the mortgage increases and correspondingly the earnings increase. At least, that's the way it is for tax purposes. That is why you pay higher taxes every year although your distribution remains unchanged.
Why You May Have to Pay More Income Taxes Every Year
If you have read the chapter about the declining balance method of depreciation, you will know that an ever-increasing portion of the distribution may become taxable because of the choice of the method of depreciation. Now let us examine the combination of the effect of the declining balance method of depreciation and of the change in the character of the mortgage payments as we have discussed them so far.
To keep our example as simple as is possible, let us assume that 30 investors pay $10,000 each and that all that money was used to pay $300,000 cash at the time of the acquisition of the building. The investors receive 10% distribution on their investment, that is $30,000. The syndicate has to pay $60,000 every year on the $600,000 mortgage. The first year, $36,000 represents interest at 6%. $24,000 of that payment on the mortgage is a repayment of the mortgage debt. So far as the collector is concerned, we have to account for an income of $54,000, the $30,000 paid out to the investors, and the $24,000 used to reduce the mortgage. (Remember, that the interest payment on the mortgage, that is the $36,000 is a deductible business expense and not subject to taxes) .
For the first year, under the declining balance method, 6% of $800,000—the value of the building exclusive of the value of the land—that is $48,000 was claimed for depreciation. Fifty-four thousand dollars of gross income less the $48,000 for depreciation leaves only $6,000 taxable income. Since the investors receive a total distribution of $30,000 and only $6,000 is taxable, 80% of the income is not subject to income taxes. They pay income taxes on only 20%.
Years later, the investors still get $30,000 (we hope). But then, out of $60,000 which the syndicate pays on the mortgage, $42,000 is applied to the reduction of the mortgage indebtedness. $18,000 is applied to interest. So we have to account for $72,000 to the collector, $42,000 which is used to reduce the mortgage, $30,000 which we pay to the investors. By that time the depreciation allowance which the syndicate may claim under the declining balance method amounts to only 2%, that is $16,000. So we have income of $72,000, less $16,000 depreciation allowance. That leaves a taxable income of $56,000. The investors get $30,000 in cash, but have to pay income taxes on $56,000. Each investor receives $1,000 a year, but pays income taxes, as if he had received $1,866. If he is in the 40% bracket, he pays $746 in taxes out of the $1,000 which he receives. This is an illustration, to show you what could happen. We hope that the manager of your syndicate won't let this happen. He probably can do something about it by refinancing the mortgage or by changing to another method of depreciation. But you as an investor must be aware of the risk that you are running.
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