DEAR BOB: Last year, my wife and I loaned our daughter and son-in-law the money they needed to buy their first home. We weren’t earning much on the money and they offered to pay us 5 percent interest. It was a good deal for them and a good deal for us. They faithfully pay us the monthly interest and principal. However, when they had their income taxes prepared, their tax adviser told them that the approximately $32,000 of interest they paid us in 2005 is not tax-deductible because it is an unsecured loan, which is not recorded against their title. Please tell us this isn’t true. –Gregg G.
DEAR GREGG: Their tax adviser is correct. For your daughter and son-in-law to deduct the interest payments paid to you as itemized home mortgage interest, the loan obligation must be secured by a recorded mortgage or deed of trust against their home.
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Although you and your wife must report on your tax returns the interest income received, the borrowers are not entitled to deduct it as home mortgage interest because the loan isn’t secured by their residence. However, this can be corrected for 2006 by their signing and recording a mortgage or deed of trust to secure the promissory note they gave to you.
SHOULD A 5.5 PERCENT HOME LOAN BE PAID OFF EARLY?
DEAR BOB: About a year ago, my husband and I refinanced our $375,000 home mortgage with a 5.5 percent interest rate loan. Now we are in a financial position to pay off our mortgage in full. But our CPA son-in-law advises against doing so. He says we need every tax deduction we can get. However, I would like to be free of the monthly mortgage payments. What do you advise? –Amy T.
DEAR AMY: Listen to your smart son-in-law. Unless you are in a very low income tax bracket, your after-tax mortgage interest rate is only about 3.5 percent. That’s a true bargain.
Surely you can find a safe place to invest that $375,000 to earn more than 3.5 percent interest. Then you will have that money available for an emergency or investment opportunity.
Another consideration is to check if your mortgage has a prepayment penalty. If it does, that settles the matter in favor of not paying off your mortgage.
HOW LONG MUST HOME BE OWNED TO QUALIFY FOR $500,000 TAX BREAK?
DEAR BOB: My friend and I have a disagreement about Internal Revenue Code 121. How long must my wife and I own our primary home to avoid tax on our capital gain up to $500,000? We purchased our home in July 2003. Can we sell it now and avoid tax on the gain up to $500,000? –Richard W.
DEAR RICHARD: To qualify for up to $500,000 tax-free principal residence sale capital gains, you and your wife must own and occupy your home at least 24 of the 60 months before its sale and file a joint tax return in the year of sale.
However, if you acquired the residence in an Internal Revenue Code 1031 tax-deferred exchange, you must own it at least 60 months to qualify with the same 24-month occupancy requirement. For full details, please consult your tax adviser.
The new Robert Bruss special report, “How to Sell Your House or Condo for Top Dollar With or Without a Real Estate Agent,” is now available for $5 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet delivery at www.bobbruss.com. Questions for this column are welcome at either address.
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