Editor’s note: The original version of this column contained mathematical errors in the sample calculation on payment of interest vs. principal reduction. We apologize for the errors. The article has been updated to delete these erroneous calculations.
DEAR BENNY: My lender just sent me a form notice suggesting that I can save a lot of money if I start making two mortgage payments each and every month. Does this make sense? –Jill
DEAR JILL: There is a trade-off on what is called a "biweekly" mortgage. Yes, you will save paying a lot of interest, but, depending on your tax bracket, your interest deductions will also be reduced.
Let’s take this example: You borrow $200,000 at 4.75 percent for 30 years. From the amortization table, you know that your monthly payment (excluding taxes and insurance) is $1,043. If you continue to pay this amount each and every month, on the 360th month you will have paid off your mortgage completely.
But let’s say that instead of paying monthly, you decide to make two payments each month. In effect, you are now making 13 monthly payments each year, which will reduce the number of years you have to pay down to between 22 and 25, instead of 30.
But does this make sense? I think not. As I have written on several occasions, you can accomplish this same goal by adding additional funds when you make your monthly mortgage. In the above example, since your monthly mortgage is $1,043, divide that by 12 and add that amount to your monthly mortgage.
You get the same benefits as with the "biweekly," but you don’t have to send in two payments. More importantly, you are not obligated to make those extra payments if your financial situation changes. With the biweekly, you must make two payments per month.
If you opt to make a larger monthly payment, make sure that you write on your check "extra payment to principal in the amount of XX," and also make a notation on any coupon that you have to send in. If you have arranged for automatic payments from your bank, send the loan servicer a letter advising that you are making additional payments toward principal.
And at the end of each year when you get your mortgage balance statement, confirm that all of that additional money has, in fact, been credited.
DEAR BENNY: I have a question that may or may not be an issue with the couple who want to "gift" the house to their disabled daughter. If the daughter’s disability is one that renders her mentally incompetent, wouldn’t that mean that she could not convey title at a later time? Doesn’t the grantor have to be mentally competent to grant title to the property?
I know the nature of the disability wasn’t disclosed in the letter in your article, but wouldn’t that be a consideration? Also, wouldn’t this be a proper situation to grant a life estate to the daughter? –Dan
DEAR DAN: You are correct. The grantor (the person who conveys real estate) must be legally and mentally competent. She must understand exactly what she is doing, or the deed may be considered invalid.
There are too many people in this country who take advantage of the misfortune of others, whether that be mental incompetence, lack of education, or anxiety over financial situations. Accordingly, when one signs a deed, it generally has to be notarized. And the person notarizing that document — and/or the attorney who prepared the deed — must be absolutely certain that the grantor fully understands the consequences of her actions.
Your suggestion that the daughter be given a life estate is a good one. That means that the daughter has the right to live in the house until she dies, and on her death, the property will go to whomever is named as the "remainderman" — i.e., the person who will own the property after her death. However, with a life estate, the person holding that estate is generally responsible for taxes, insurance and maintenance. Accordingly, if such a life estate is created, the document spelling this out should make it clear who will be responsible for these expenses.
There is another alternative. If the daughter is mentally incompetent, the father can petition the local court to have a guardian and conservator appointed for his daughter. Generally, the guardian takes care of the physical needs of the ward, while the conservator handles the financial issues. Of course, while the father is alive and mentally alert, he should be handling all of this without the need for court intervention.
TAX ALERT: I receive a large number of email questions on a monthly basis, and try to answer as many as I can. I wish I could respond personally to everyone, but that is not possible.
Although many questions are unique and different, one issue predominates, namely: "I want to gift my property to my children." Readers will know that under most circumstances, I do not like this idea, as there are usually tax consequences. As I have written many times before (and suspect I will continue to write), "the tax basis of the giver of the property (the giftor) becomes the tax basis of the recipient of the gift (the giftee)."
This means that if the parents bought the house years ago for $100,000 and it is now worth $500,000 (yes appreciation still happens despite our current economy), the kids’ basis for tax purposes is $100,000. (Of course, if the parents made major improvements, that would increase their tax basis).
Unless the kids actually end up owning and living in the property for two out of the five years before it is sold, they will have to pay a large capital gains tax to the IRS. In this example, if the kids sold the house immediately after the parents died for $500,000, their gain would be $400,000 ($500,000 minus the tax basis of $100,000). Currently, the federal capital gains tax rate is 15 percent, which means they will have to pay upwards of $60,000 to the IRS, plus any applicable state and local tax.
However, if they inherited the property, they would be able to take advantage of the "stepped up" basis, which means that the value of the house on the parents’ death becomes the tax basis of the beneficiaries. Thus, in this example, if the house was sold for $500,000, there would be no capital gains tax to pay.
But now there is yet another problem with gifting the house. The IRS has mounted a major campaign to ferret out unreported taxable gifts. I understand that IRS agents are reviewing thousands of county real estate transactions, to determine if the giftor properly filed a gift tax return.
Currently, taxpayers can gift (tax-free to everyone) up to $13,000 to individuals. You can gift this amount to each of your children, and if you are married, both you and your spouse can make similar gifts. However, gifting a house clearly is more than $13,000. If that’s the case, you have to file a gift tax return. There is no immediate tax consequence, but it may impact on your lifetime exemptions. (Check with your local tax advisers for more details.)
The bottom line, however, is that the IRS is watching and you should be very careful and get good tax and legal advice before you make that gift.