Rental Property Complicates the Tax Picture
Q: I have a single-family home in which I lived for nine years before converting it into a rental. The house has a $50,000 mortgage on it, but is worth $200,000. I would like to refinance the mortgage and take equity out of the house.
Can I still get a tax deduction on the new mortgage?
What is the maximum tax-deductible mortgage allowed on a rental house? --A.G.
A: Because this home is neither your first nor second residence, if your newly refinanced mortgage exceeds $50,000, the critical issue is not its actual amount, but the use to which you put the proceeds. If you use the money for a purpose that is considered tax deductible, then the mortgage interest is deductible; if not, then it’s not.
So, what’s deductible? Investments are a tax-deductible activity, but your expenses can only be used to offset your investment income. Operating a business is another activity that generates tax deductions, but again your expenses must be offset by business income. The Internal Revenue Service employs what is known as the “tracing rule,” which allows it to follow how the money is used before determining whether a deduction is allowed.
However, if your new loan were secured by your primary residence or a qualifying second home, the tax code would have allowed you to deduct the interest on a home equity loan up to a maximum of $100,000 regardless of how you used the loan proceeds. But because your loan is secured by a piece of investment property--the fact that the house was once your primary residence doesn’t matter at all--you do not qualify for this treatment under the law.
Carter Hawley Hale: Tracking Stock Switch
Q: I own 3,000 shares of Carter Hawley Hale stock that I purchased for a total of $4,575. I try to track my investment but have been frustrated since the company decided to swap its old stock for new shares and warrants following its emergence from bankruptcy reorganization earlier this month. Just how many of the new shares and warrants am I entitled to receive? And when will I get them? --P.H.
A: The conversion of old Carter Hawley Hale shares for new stock and warrants took place on Oct. 9, the direct result of a new financing plan that brought the retailer--parent of the Broadway department stores--out of bankruptcy. For every share of old stock, CHH shareholders were given .081 of a share of new stock and .084 of a warrant. Your 3,000 old shares entitle you to 243 shares of new stock and 252 warrants. The warrants entitle you to purchase additional shares of CHH at $17 each until Oct. 8, 1999. Practically speaking, you can exercise these warrants only if CHH shares trade above $17 sometime over the next seven years.
As of the Oct. 9 conversion date, when new CHH shares were valued at $6.50 and warrants were priced at $3 each, your CHH stake was worth $2,335.50, about half your original investment. Since that date, however, trading prices of both the warrants and the shares have dropped. You can track the movements of your stock and warrants in the New York Stock Exchange listings carried in the business sections of most newspapers.
The Bank of America is acting as the transfer agent for the exchange of old shares for new stock and warrants. According to a spokesman for Carter Hawley Hale, the bank should be contacting you--or your broker if your shares are held in a street name--with information about the swap sometime soon.
Avoiding Capital Gains in a Move Out of State
Q: We are selling our home in California for $275,000 and will be buying a home in Arizona for $150,000. We are both over age 55 and will be using the $125,000 exclusion on home sale profits. Will we have to pay any capital gains to the state since we are moving out of California? --B.O.B.
A: No. By purchasing a home for at least $150,000 anywhere in the world, you have satisfied both your California and federal obligation to reinvest your home sale gains.
Fair Market Value Is Key to Property Gift
Q: My wife and I purchased 89 acres of dry land 30 years ago for about $140 an acre, or a total cost of $12,500. Today, neighboring land is selling for $3,500 per acre, giving our property a potential value of $311,500. We are thinking of giving this land to our three children in annual increments of $20,000. May we value the land at whatever we want or do we have to value it at what our greedy neighbors have recent sold for? --R.E.D.
A: The law requires you to use the fair market value of the land at the time of the gift; you may not establish your own value for the land. Why? The answer should be obvious. If Uncle Sam allowed taxpayers to set their own value on gifts they made to friends and family, these assets would never be sold at a taxable gain to anyone and the government would never get its share of the take.
May we offer a bit of unsolicited advice? Before giving your children this land, consider the fact that by making this gift before your death, you are passing along the original tax basis of the land: $140 per acre. If they sell the land at a future point, they would be taxed on the difference between that amount and the sale price, a potentially hefty amount. However, if you wait and bequest the land to them upon your death, the tax basis of the inherited property (or any other asset passed on at death) is set as of the donor’s date of death. Then, when your heirs sell the asset, their taxable gain is significantly lowered, or possibly eliminated.
