DEAR BENNY: We carry the first and only mortgage on our married daughter’s house, which is approximately $200,000. Without our knowledge they obtained an equity loan on the house for $100,000.

Our son-in-law has since lost his job and we are carrying them on the first mortgage. If he defaults on the equity loan, what effect does this have on us? –Joan

DEAR JOAN: An equity loan — usually called a "home equity loan" or a "HELOC" — is a second mortgage (in many states it is called a "deed of trust"). And basically, as with a first trust, the HELOC lender can foreclose on the property if their loan is in default. However, the second lender must advise the first trust lender (which you are) of the pending foreclosure, and that would give you the right to pay off the second so as to keep the property.

Alternatively, if you should opt not to make the payment and the house is sold, you will receive your proceeds first because you are in first trust position.

What this means in real life is that most second trust holders are reluctant to institute foreclosure proceedings. There is an expense involved (such as advertising, auction and legal fees) that the HELOC bank may not want to spend if they believe the foreclosure sale will not generate any money for them.

You or your attorney may want to discuss the situation with the HELOC holder and see if you can work out some kind of amicable resolution.

DEAR BENNY: In January 2005 our daughter bought a home for $125,900. My ex-wife and I co-signed so she could get the loan. My daughter made all the payments and lived in the home until March 2008 when she sold it for $145,000 and bought another home for $259,000.

We each received a Form 1099 showing the gross receipts from the sale divided by three, which was about $48,000 for each. The net receipt was $11,367, which my daughter kept.

I know she does not have to pay taxes on it because she made less than $250,000 profit, but do my ex and I have any liability in this? Do we have to show a third of the profit on our taxes? Do we have to do anything? –John

DEAR JOHN: I am not an accountant, so I don’t know exactly how you should handle this. I do know, however, that since neither you nor your ex-wife were on title, neither of you made a profit and thus do not have to pay any tax.

However, because you both received a Form 1099 and those forms go to the Internal Revenue Service, you need to file an explanation when you complete your 2008 tax return.

Perhaps the best approach would be to get a copy of the deed to your daughter’s house, which would clearly indicate that she was the sole owner. Attach a copy of that deed to your income tax return, with a brief explanation that although you received Form 1099, neither you nor your ex were on title.

You may also go back to the settlement company/attorney that sent you the form, and ask them to issue a correction.

DEAR BENNY: My wife and I have owned a rental duplex since 1986. Recently while cleaning up my files I noticed that the warranty deed for the duplex shows both our names, followed with "Husband and Wife." My wife thinks I should have the "Husband and Wife" changed to "WROS" (with right of survivor). What’s your advice? –Roy

DEAR ROY: Different states have different requirements, so my response has to be general in nature. In some states, the words "husband and wife" will automatically create a "right of survivorship."

In my opinion, however, if your state allows title to be held as "tenants by the entireties" (t/e), that would be the best way to handle your situation. A "T/E" tenancy is reserved exclusively for husbands and wives, and provides greater protection against creditors. On the death of one spouse, the survivor will automatically own the entire property, and probate will not be necessary.

However, I suggest you discuss your specific situation with a local real estate attorney.

DEAR BENNY: Recently, you addressed the issue of combining the gain from a sale made under the old rollover rule with the gain on a home being sold under the new $500,000 exemption rule. The article raised two questions:

1. If I had a gain on a sale in 2000 of $250,000 and a gain of $300,000 on a sale in 2008, and all the residency criteria were met, would I owe tax on $50,000 gain ($250,000 + $300,000 – $500,000 = $50,000)?

2. If I have, over the course of years, sold several homes under the rollover rule, and now sell my current home, do I need to add the gains from each sale to determine the total gain before applying the $500,000 exemption?

I read your column every week and cannot remember ever seeing the issue of "accumulated gains" being explained. –Frank

DEAR FRANK: May 6, 1997, is the target date. For sales that took place after that date, you are eligible to exclude up to $500,000 of your gain if you are married and file a joint income tax return (or up to $250,000 of gain if you file a separate tax return).

You can take the exclusion every two years, although you are eligible only if you have owned and lived in the house for two out of the five years before it is sold. This is called the "use and ownership" tests.

Thus, the answer to your first question is that you would owe no tax. The sales took place after the target date, and since you meet the use and ownership tests — and you file a joint income tax return with your spouse — you can exclude the profit from both houses.

The answer to your second question is more complicated. Let’s take this example: In 1990, you bought a house for $100,000, and sold it in 1992 for $200,000. In that same year, you bought a second house for $300,000. However, since you were able to take advantage of the old rollover rules, the $100,000 profit was deferred; although you paid $300,000 for the new house, your basis for tax purposes became $200,000 ($300,000 – $100,000).

In 1996, you sold the second home for $500,000 and bought a new one for $600,000. Although it would appear on paper that you made a profit of $200,000 on this sale, because the rollover reduced the tax basis, in fact you made a profit for tax purposes of $300,000 ($500,000 – $200,000).

NOTE: For purposes of this discussion, I am ignoring any improvements that would increase your tax basis, as well as any costs that you paid associated with your purchase and sale, such as closing costs and real estate commissions.

So, in our example, your third house (that you paid $600,000) now has a tax basis of $300,000 ($600,000 – $300,000).

We are no longer using the rollover. If you subsequently sell the current house for $800,000 or less (and if you file a joint tax return and meet the use and ownership tests), you will not have to pay any profit. However, once the sales price exceeds $800,000, you will have to pay a capital gains tax on that difference — and the current federal rate is 15 percent.

This example clearly shows the value — and the benefits — of keeping accurate records of all improvements that you have made over the years. Every dollar of capital improvements will add a dollar to your tax basis. This also makes it clear that you should keep all of your settlement statements (HUD-1), because some of the items on those documents can be used to reduce your tax liability.

Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

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