Walking tightrope with underwater buyer

DEAR BENNY: I hold a $175,000 second trust on a house I sold five years ago. It has been payable "interest only" monthly at 5 percent. It comes due early next year and although I need the principal I have a feeling the debtor will want an extension of the loan. How much can I increase the interest and yet avoid it being usurious. I do not know how much of a first mortgage he has.

Also if he offers to pay it off but at a discount, how much should I discount it? I sold him the house for $475,000, but it is probably worth only $350,000 at present. --Doug

DEAR DOUG: Different states have different usury laws, so you should ask your attorney for the laws in your state. But clearly, whatever the usury laws are, I don't think you want to increase the rate too much or you will scare off your borrower. More importantly, you want to make sure that he is able to make his monthly payments; the last thing you want is to have him default on your loan.

As to what discount you should offer him should he want to pay you off in full, there really is no set formula. Let him make the first offer, and then if that's not acceptable, you can counter. There may be some back-and-forth negotiation until you finally reach agreement.

But don't be too greedy; his house is upside down and unless he has an incentive to pay off his second mortgage, he may just let the property to go foreclosure. If that happens, and the first lender forecloses, your trust will be wiped out. You can still sue on the promissory note he signed, but that could be expensive and litigation is always uncertain.

DEAR BENNY: Is the definition of "capital improvement" something that increases the actual value of the house, even if it may not trigger change in taxes, or must it be taxable?

If the first, is there a dollar figure that could be considered a "floor"? When we bought our house we discovered many unsafe issues, such as no railings on steps leading down from the deck and, notably, unsafe steps exiting the house into garage. We built a landing with better, safer stairs at the dangerous exit; the cost was $400. The railings cost $100. Our corrections have made our house safer, but they didn't lead to a rise in taxes and they will not lead to an increase in sales price. Are additions directed to safety considered repairs or capital improvements? --Phyllis

DEAR PHYLLIS: The line between repairs and improvements is fuzzy. The court cases that have analyzed this issue are all over the place, with judges deciding the exact same work going in opposite directions.

If your property is a rental, then in most cases you want to call the work a repair. Repairs can be deducted as rental expenses in the year that you pay them, thereby reducing your rental income.

If this is your principal residence, however, while you obviously want to keep your house in good repair, the money you spend on ordinary maintenance provides no taxable benefits for you.

Improvements, on the other hand, may be very valuable to you when you sell your house, since they increase the tax basis in your house. The higher the basis, the less tax you have to pay. ...CONTINUED

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