As mentioned in my last post there are a few downsides to financing out, or at least factors to consider. The main factor to consider in financing out is the long term impact of Phantom Income. Phantom income is the byproduct of shifting percentages of principal and interest as a mortgage is paid down. Per usual here is an example to
clearly explain the concept:
Example: I have acquired and rehabbed an office building. I did a great job leasing the space and can use the power of financing out to return all of my equity and have all debt on the building. As explained in financing out once all my equity is returned my risks are greatly reduced and I sit back and take in annual cash flows after financing (aka free cash flow).
So,
NOI $100
Annual Debt Obligation -$95
Year 1 Principal Paid $22
Year 2 Interest Paid $73
Free Cash Flow $5
Tax Analysis
NOI $100
less: Interest $73 (Tax Deductible)
less: Depreciation (35–steady throughout 39 years)
Income in eyes of the IRS: Loss Carry of -$8
However, the principal and interest ratio changes as the loan is
amortized (principal payments increase as the loan matures).
10 years pass:
Year 10
NOI $100 ( no rent bumps)
Annual Debt Obligation -$95
Year 1 Principal Paid $50
Year 2 Interest Paid $45
Free Cash Flow $5
Tax Analysis
NOI $100
Less deductible interest: $45
Less Depreciation: $35
Income in eyes of gov’t: $20
Taxed @ 35% leaves you with an obligation to pay $7. We only took in $5
in cash flow for the year so there is $2 of phantom income.
Cheers,
John
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