Prepaying Debt May Add to Taxes
QUESTION: I have been thinking about paying off my mortgage before it is due because my lender promises to cut almost $10,000 off my principal if I do. The only reason I hesitate is that I have a nagging feeling that I read several months ago that prepaying isn’t such a great idea. Am I dreaming or am I right to hesitate?--F. J.
ANSWER: Your lender’s offer may turn out to be a great deal, but you are right to question it. For starters, you can bet that if your lender is willing to forgive almost $10,000, it isn’t because he’s a great humanitarian. It’s because he stands to gain substantially, too. Your interest rate must be incredibly low if he figures to cut $10,000 off the principal and still come out ahead by relending the money at going interest rates. While higher than they were a few months ago, mortgage rates are still substantially lower than they were in the early 1980s.
The second consideration is one that even the wisest of homeowners often overlook: Taxes. Believe it or not, the IRS taxes the difference between the amount you repay and the amount you were supposed to repay.
Its reasoning? When a lender forgives part of a debt, he is reducing the debt without reducing the value of the asset it backs by a like amount. Thus, the borrower in effect gets an economic gain, which is taxable income to the IRS.
Several tax court decisions back this logic, so be sure to figure in the cost of taxes on this so-called income before you seal any deal with your lender.
Q: I recently noted in your column a discussion regarding a provision in the new tax law that provides for faster vesting of pension rights. Does the new countdown of years begin in 1988 or when the individual started his or her participation in the pension plan? I became a participant in my company’s retirement plan in March, 1984, and I still don’t understand when I can expect to become vested.--W. B. C.
A: The new vesting laws take effect in 1988, but the countdown begins from the day you became a participant in your employer’s retirement plan.
So, depending on whether your company chooses the five-year vesting plan or the seven-year option--the new tax law requires one or the other--you will be vested in March, 1989, or March, 1991.
Q: I just took a sales job with a car dealer, and my boss assures me that I won’t have to report the demo they give me to drive to the IRS and pay taxes on it. But I don’t want to take their word for it and then find out too late they were wrong. Do you know the answer?--K. L.
A: As long as the dealership puts some restrictions on your use of the car for personal reasons, the tax code considers the use of a so-called demonstrator car by a car salesman to be a non-taxable benefit.
Q: I see references all the time to people investing in foreign stocks. I’m not sure that is something I’d feel comfortable doing, but I would like to know how to go about doing it if I decide I’m interested. Can you explain it to me?--A. R.
A: It can be as easy as investing in U.S. stocks. Many investors, in fact, simply buy foreign stocks on the same exchange where they buy shares in U.S. companies. Many foreign issues now trade on the New York and American stock exchanges; even more are available over the counter.
If you don’t want to do the research into foreign stocks yourself--translating foreign accounting to make sure you’re comparing apples with apples is a problem--you might instead consider a foreign stock fund.
More than 100 mutual funds now specialize in foreign investment, and some of those specialize still further. There are funds, for example, that invest only in the stocks of companies in a single country. Others invest in a single region, such as the Pacific Basin. And so-called international funds will invest in a wide variety of foreign securities.
A third option is to avoid stock exchanges and deal, instead, with the company and a U.S. bank. The bank will issue you a negotiable receipt called an American depositary receipt. This, essentially, is one share of stock in the foreign company you’ve selected. Dividends on stocks bought this way are paid in U.S. dollars--a plus. But many are subject to withholding tax by the country of origin--a minus. Of course, you can claim a credit for this foreign tax withholding on your U.S. income tax return. But, in the interim, it is money you can’t use.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Los Angeles Times, 780 Third Ave., Suite 3801, New York, N.Y. 10017.
