The Big Benefit to Paying a Prepayment Penalty

With interest rates steadily increasing, more and more borrowers are considering refinancing early into a low rate and paying the prepayment penalty. The strategy isn’t for everyone, and generally only works if the borrower is looking to pull equity out of the property. However, there is one big benefit that seems to fall under the radar: a tax write off. Prepayment penalties are tax deductible in the State of California and at the federal level, meaning that the penalty could be reduced by half for borrowers in the top tax brackets.

“For both federal and state tax purposes, prepayment penalties are tax deductible against ordinary income,” Michael T. Elmore, EVP and managing director at NorthMarq Capital, tells GlobeSt.com. “In California with high-income owners—with a federal tax rate of 37% and the state tax rate is 13.3% at the margin—the federal and state government are giving you half of the money back as a write off against your ordinary income.”

The savings depends on your tax bracket, but for high-income borrowers, the tax write off can mean a substantial savings and could make refinancing early more attractive. “If you are a top-margin taxpayer, you are really only paying half of that penalty and the government is absorbing the other half between the state and federal government,” explains Elmore. “If you are in the top income bracket, you are paying more than 50%, so is very desirable to have a prepayment penalty.”

Of course, the tax write off alone isn’t enough to offset paying a prepayment penalty. The loan structure, timing and details of the deal and the asset all play a role in determining if this is an option. “That is just a discount. The way that it makes sense is to capture a substantial amount of equity between the two properties in addition to locking the rate,” says Elmore.

While the tax deduction can help, Elmore says that the early refinancings that require a prepayment penalty are best for deals where the borrower is pulling substantial equity out of the property. He recently completed two such deals in Norwalk and Santa Ana. “A prepayment penalty makes the most sense if you are leveraging up the asset. If you are only trading the debt, it is less compelling. In these two properties, the borrower was doubling the loan amount,” Elmore explains. “When you weigh that prepayment penalty against the new loan balance, it becomes very reasonable. So, you are able to recapture equity and you are hedging the interest rate early.”