How a Small Down Payment Can Pay Off for Retiree Buying Home
QUESTION: Your recent answer to another reader advising a small down payment on a home purchase has me puzzled. My wife and I plan to sell our home, use the $125,000 “over 55 rule” tax exemption, and walk away with lots of cash. Then we expect to use that cash to buy a retirement home and not have any mortgage payments to make. Is there anything wrong with this plan?
ANSWER: Yes. I’ll presume you have consulted your tax adviser to learn how to structure your home sale to avoid tax on your sale profit if it exceeds $125,000. As you probably know, you can avoid tax on a sale profit over $125,000 by also using the “rollover residence replacement rule” of IRC 1034.
This tax-deferral benefit is available to all home sellers who buy a replacement principal residence costing at least as much as their old home’s net (adjusted) sales price.
For example, suppose you sell your old home for $275,000 and use the $125,000 “over 55 rule” to bring your “revised adjusted sales price” down to $150,000. Then, if you buy a replacement principal residence within 24 months costing at least $150,000, you can defer tax on the remainder of your sale profit by combining these two tax breaks.
But I do not advise you to use all the cash from your home sale to buy a retirement home with no mortgage. The reason is that the 1987 Tax Act makes low down payments and big mortgages on home purchases very smart.
This new tax law says you can deduct interest on a home acquisition loan up to $1 million. In addition, you can deduct interest on a home-equity loan up to $100,000.
The unfortunate tax result is if you buy your home for all cash and later change your mind, you can only deduct home loan interest on a $100,000 maximum home-equity loan. Another advantage of making a low- or no-down payment is if the home goes up in market value, thanks to the magic of leverage, the percentage return per dollar invested is maximized with a low down payment.
An additional problem for retirees who make a big cash down payment is if they later need cash for emergencies or investments, they may not be able to borrow on their home equity except at loan shark rates. Of course, a retiree should not make such a small down payment and obtain a big mortgage with payments that cannot be comfortably made from available income. That would be foolish.
Buyer Stalls While Shopping for Loan
Q: We are trying to sell our home. But I think our realty agent is the biggest obstacle. She brought us a purchase offer that was pretty close to our asking price.
However, the agent neglected to point out it contained a clause that says, “This offer contingent upon buyer arranging the maximum mortgage available at current market interest rate and terms.” That was three months ago.
The buyer says he is still shopping for a mortgage. But we know he is stalling in hopes interest rates will drop further. We have offered to refund his deposit but the buyer refuses to accept it. What can we do to either force the buyer to close the sale or cancel the purchase?
A: Your situation shows the pitfalls of accepting an open-end property purchase offer. Shame on your real estate agent for not emphasizing to you the consequences of that vague, indefinite contingency clause in the offer.
After consulting your attorney, I suggest you consider giving the buyer written notice to either close the sale within 30 days or consider the transaction canceled. Fortunately, the finance contingency clause is so vague the buyer would be on risky grounds suing you for specific performance of the purchase contract when you cancel and put the property back on the market for sale.
Tax Pitfalls in Gift Before Owner’s Death
Q: My mother was told she needed heart surgery. Since she was not expected to survive, she insisted on deeding her home to me and my sister. Unfortunately, my mother died during surgery. Now we are trying to settle her estate. My sister and I are the only heirs. We plan to sell the home because neither of us wants to keep it, as we live in distant cities. But the estate attorney says we will owe a tremendous tax. Our mother and father paid about $20,000 for the house, which is now worth more than $400,000. The attorney says we owe tax on the difference. Is this true?
A: Not exactly. Your mother’s big mistake was deeding her home to you before she died. You would have been much better off receiving it as an inheritance.
As recipients, your basis is the same as your mother’s. If you had received the house as an inheritance, your basis would be its $400,000 market value on the day of her death, and you would owe virtually no profit tax if it sells for around $400,000.
If your mother and father paid $20,000 for the house, when your father died your mother received a stepped-up basis on at least his half of the house. Depending on when he died, your mother’s basis was probably much higher than $20,000. Please consult your tax adviser to straighten out your tax mess.
Equity-Share Partner Not Easy to Evict
Q: Last week I attended a seminar about equity sharing sponsored by a local real estate firm that wants to sell homes. They are trying to recruit investors to enter into equity-sharing contracts with residents who will occupy homes and make the monthly payments.
As I understand their program, the investor makes 90% of the down payment and the resident pays 10% of the down payment. Everyone signs a contract requiring the resident to pay the monthly mortgage payments, property taxes and maintenance. The resident owns 67% of the house and the investor owns 33%.
Someone in the audience asked what happens if the resident doesn’t make the payments. The broker said the resident is then evicted and the investor owns the house. I talked this over with my lawyer but he doubts that is legal. The brokerage company refused to give me a copy of its equity-sharing contract for my lawyer to review. What do you think about equity sharing?
A: I think equity sharing is a wonderful arrangement between parents and their adult offspring. It’s a great way for the parents to help with the down payment but their children pay the monthly expenses. Since the parents have known their children at least 20 years, they know if the kids can be trusted to make the monthly payments without any hassle. But equity sharing among strangers is often not so successful.
As you probably know, Internal Revenue Code 280A authorizes equity-sharing tax deductions. It requires the non-resident investor and the resident to both be on the title and to have an equity-sharing contract.
If the resident co-owner does not make the monthly payments, you can’t evict a co-owner like you would evict a deadbeat tenant. In most states it is necessary to go to court in a quiet-title or other lawsuit. Such legal proceedings can take many months. This is the big drawback of equity sharing.
I’m not surprised the realty broker promoting equity-sharing home sales did not want to give you a copy of the contract to have your attorney review. Most equity-sharing agreements do not adequately protect the investor in the event of the resident co-owner’s default. Further details are in my special report “How Equity Sharing Works, Especially Between Parents and Their Adult Children,” available for $3.50 from Newspaperbooks, 64 E. Concord St., Orlando, Fla. 32801.
Should Inheritance Pay Off Mortgage?
Q: My husband recently inherited about $135,000. I think we should use it to pay off our mortgage of about $120,000 and use the rest to pay off our car loan and small bills. But he wants to save half and use the other half to buy one or two rental houses. How can I convince him to pay off the mortgage so we won’t have to make any mortgage payments?
A: Sorry, I think it would be a major mistake to pay off your home loan. If you and your husband can comfortably afford the monthly payments, in my opinion your husband has an excellent plan to buy some real estate investment properties. He is planning for the future, whereas you are looking only at the immediate picture.
Your home is probably the best investment you ever made. Then why not invest in several more houses? I’m in your husband’s corner on this one.
Don’t Sell Home If Plan to Return There
Q: My husband is in the military and has one more transfer before retirement. We like our present home and plan to return here to retire in about three years. When he is transferred, should we sell our current home or try to rent it? I know you don’t recommend owning property far from home but do you think this is an exception?
A: Yes. If you plan to return to the community and like your present home, don’t sell it. Rent it while you are gone. Make arrangements with a trusted friend or realty agent to manage the house while you are gone.
If you sell and then try to buy back into the community in a few years, your sale and purchase costs will far exceed any negative cash flow you might have on a rental while you’re gone. Also, don’t forget you can claim depreciation deductions on your tax returns while the house is rented. See your CPA for full details on the tax benefits.
