Parents Can Boost Discretionary Income by Paying Off Mortgage on Rental Property

Q. My parents are in their 70s. They own a piece of rental property with a mortgage of about $350,000 that carries an 8.25% interest rate. The monthly payment is about $2,400. They are thinking of paying off the mortgage in order to have more discretionary income. Right now, their annual income from investments--they are both retired--is about $150,000. The funds to pay off this mortgage would come from their substantial savings--certificates of deposit currently paying about 6%. They wonder if their strategy makes sense and if there are any income tax implications. They are already in the highest bracket for both state and federal taxes. What do your experts say?

--S.P.L.

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A. We took your question to a few experts who agreed, with only a few minor caveats, that your parents would be better off if they paid off the mortgage to boost their discretionary income and, it is hoped, get more enjoyment out of their retirement. After all, if you’ve spent your life amassing a nest egg, there’s no sense in not enjoying it. Here’s their analysis.

This maneuver makes the most sense if your parents won’t face a prepayment penalty on either their CDs or mortgage, and if their CDs are not held in individual retirement accounts, 401(k) plans or other tax-deferred investments. Why? Because the penalties would substantially reduce the benefits of the mortgage payoff, as would a tax bill when the savings accounts were cashed out--especially given your parents’ tax bracket. Perhaps more important, however, is a warning that your parents shouldn’t attempt this strategy if it would deplete or even seriously erode their savings. There’s no point in exposing themselves to any financial uncertainties at their age. Finally, there’s the issue of the mortgage rate versus the savings rate. The former should be higher for this plan to make the most sense.

Your parents are proposing to tap their considerable savings to enhance their lifestyle. And they propose doing it in a wise fashion by trading the mortgage tax deduction for cash flow. Remember that even though your parents are in a high tax bracket, increasing the advantage of any tax deductions, the fact is that for every dollar in mortgage interest they pay, they receive less than 50 cents of tax write-off. This means that they are spending more than $2 to save $1 in taxes. Furthermore, they should look at what they will save in interest payments over the life of the mortgage.

What about the tax consequences? Sure, losing the mortgage deduction is likely to increase their taxable income. But don’t forget that by cashing in CDs, they are giving up the interest income on the $350,000. Here’s the math: The deductions drop by about $28,000 per year, while the income dips $21,000. The conclusion: Pay off the mortgage!

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Q. We purchased a house in Alameda County after selling our home in Ventura County. The new home cost less than what we received from the sale of the old.

What are the procedures for transferring our old property tax basis to our new home?

G.L.G.

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A. There are two special property tax reassessment programs available to California home buyers provided that you are over age 55. The first allows you to transfer the assessed value of the home they were selling to a new home. This initiative, approved by state voters in 1986 and known as Proposition 60, permits older homeowners to bypass provisions of Proposition 13, which automatically set the sales price of a home as its assessed value. However, this program contains two important restrictions: The replacement house must be of equal or lesser value than the old home, and both the old and replacement homes must be in the same county.

However, the second program, approved by voters in 1988 as Proposition 90, allows homeowners over age 55 to transfer the assessed value of their old home anywhere within the state as long as the value of the new home is the same or less than that of the old. But the initiative stipulates that homeowners can take advantage of Proposition 90 only if the county into which they are moving votes to participate in the special property assessment program.

Currently, the boards of supervisors of just 10 counties--Alameda, Kern, Los Angeles, Marin, Modoc, Orange, Santa Clara, San Diego, San Mateo and Ventura--have agreed to participate.

You should mark the box for a Proposition 90 exemption on the Preliminary Change in Ownership Report that is filed with the county recorder’s office after you purchase your new home. Later, when the county assessor’s office sends you a Change in Ownership Statement, you must mark the box on that form signaling that you are eligible for the exemption.

Also, be aware that the sale and purchase prices of the two dwellings are not always the same as “fair market value.” The county assessor must determine the market value for each property. If the fair market value of the replacement house exceeds the allowable limit--even by a small amount--the transfer of the old assessed value cannot take place. There is no partial benefit. This tax break can be used only once and is available only if the home being sold is the taxpayer’s principal residence.

For more information on propositions 60 and 90, write to the State Board of Equalization’s Property Taxes Department, Real Property Technical Services Unit, P.O. Box 942879, Sacramento, CA 94279-0064.