Better to pay off mortgage than keep investment

I own three houses, one that I live in and two rental houses.

Two are mortgage-free and one has a mortgage of about $55,000, which will be fully paid by December 2009. I also have about $40,000 in term deposits. In July 2007 I will qualify for NZ Super, and intend to retire shortly after that.

Now my question is, should I pay off the balance of the mortgage, in a lump sum when I retire, or let it run its course?

If I don't pay it off, my only income will be the pension (though that doesn't particularly worry me).

The balance owing at that time will be about $20,000. The mortgage payments are $720 a fortnight and the rents total $545 a fortnight. There are just the usual outgoings of rates, insurance, etc.

Friends say I shouldn't pay off the mortgage, because then I will be paying a lot of tax. However, if I don't pay it off, I will be paying interest.

Any tax paid will benefit the country by helping to fund health care, education, etc, whereas interest will go to a foreign-owned bank and presumably benefit its shareholders.

Therefore, wouldn't it be better to pay tax?

Nice attitude to tax. It would be great if the people who set up trusts or make other fancy moves to dodge tax thought more like you about the point of the tax system and their contribution to it.

But even if that argument wasn't there, I'm on your side, not your friends'.

My father, who was a businessman, used to say, "The only thing worse than paying tax is not paying tax", because that meant the business wasn't making a profit. It's always better to have taxed income than no income.

Since then, though, I've come across landlords who like the fact that their rental income doesn't cover all their expenses, because that gives them a loss to deduct against their other income.

Huh? Why don't they just reduce the rent to zero? Then they will have an even bigger loss, and pay even less tax.

I'm not saying that an investment that doesn't pay its way year by year is bad. It may make a big enough profit later to more than make up for that. But an investment that makes ongoing profits as well as a capital gain is even better.

Landlords who judge their investment by simply subtracting their inputs over the years from their final profit should note the time value of money: a dollar today is worth much more than a dollar in five years, which is worth much more than a dollar in 20 years. That's partly because of inflation, but also because you can earn a return on the money in the meantime.

I suspect many landlords would be shocked if they realised how much their annual inputs would have totalled if they had invested the money elsewhere instead, with compounding returns.

It would certainly take the shine off some capital gains.

But let's get back to you. I reckon you should pay off the mortgage when you retire. Better still, use your term deposit money, when it matures, towards repaying the loan as soon as possible. Then use any future savings the same way, until the mortgage has gone.

Why? You're paying higher interest on the mortgage than you're earning on your term deposits.

Sure, your mortgage interest is tax deductible if the mortgaged property is a rental - and I hope it is. But the term deposit interest is taxable, so that cancels out that advantage.

A couple of caveats: if your mortgage is fixed rate, make sure you don't face an early repayment penalty. Discuss this with your lender. Also, make sure you can increase the mortgage again if you need money for an emergency.

Some readers may be scratching their heads over all this.

One big advantage of investing in mortgaged rental properties is that you benefit from the growth on the borrowed money as well as on your deposit. So why pay back the mortgage faster than necessary?

As I've said many times, borrowing to invest increases your risk. That might be fine when you've got years of high income ahead of you and plenty of time to recover if things go wrong.

But most people, as they approach retirement, want to reduce their investment risk.

You've done well, acquiring three almost mortgage-free houses. I would encourage you to not only get rid of the mortgage so you can enjoy the rental income, but to consider selling at least one of the properties so you can also enjoy spending the capital.

Early in retirement is surely the time to reap what you've sown.

After reading your article last weekend I would like to ask for your thoughts again about the guy who was told by his broker to sell his shares and take capital profits after owning the shares for two years.

I have a friend who works in the tax field, and they tell me that paying tax on profits depends on your intentions at the time of purchase, ie were you ever going to sell or just hold for a long-term investment?

Imagine that someone buys a truck and sells it later at a profit. Is that profit taxable?

Well, if that person was a truck dealer, the truck would have been part of his stock. He intends to buy and then sell trucks at a profit. That's how he makes a living. The sale of the truck would therefore be part of his income and therefore taxable.

If the guy just owned one truck for two years, say, and then decided to sell it on and he made a profit, in my eyes he wouldn't have to pay tax on any profits, would he, as he's not a dealer.

There's no capital gains tax when you sell investment property. The profits are not taxable. This is true in most cases except property developers and traders.

The cases are the same for shares in my view. Your thoughts please.

You apparently mix with more knowledgeable people than our correspondent above. Your friend is right. Generally, whether you have to pay tax on a profit depends on your "dominant purpose" when you bought.

That applies to shares, trucks, works of art, merry-go-rounds and, in most cases, property.

If you make a living by buying and selling anything, you will be taxed on your gains because, as you say, that is your income.

That doesn't mean, however, that you won't be taxed if you sell something at a gain but that's not what you do for a crust.

What matters most is whether your main reason for buying was to make a profit later.

How can Inland Revenue prove how you were thinking when you bought? They're not mind readers. But those who have dealt with them say they look at such things as what you might have said to a broker or bank at the time, and your patterns of behaviour.

If you repeatedly claim you buy shares, property or whatever for life and then, lo and behold, change your mind and sell them a few years later, that looks a little suspect.

Which brings us to an interesting point about property.

Your statement that there is no tax when you sell investment property unless you are a developer or trader is not quite correct. You might buy and sell just one property but still be taxed on the gain, if your main purpose was to make that gain.

As I said above, it's not uncommon for landlords these days to find their expenses exceed their rental income. They're hoping they'll make a big enough gain on sale to more than compensate for that.

If the IRD asked them a few probing questions after they sold, I don't like their chances of keeping that gain untaxed.

* Mary Holm is a seminar presenter, author of Investing Made Simple, and publisher of Holm Truths, a quarterly newsletter for employees, clients and superannuation scheme members.