ASK THE EXPERT: ANSWERS TO YOUR QUESTIONS Home-equity loans, shifting gain, eternal rollovers, state bonds
(MONEY Magazine) – These questions are answered in collaboration with James B. Conley, a tax partner with the accounting firm Arthur Young & Co. in Washington, D.C.
Q. We are empty-nesters with a paid-off house and no tax deductions. Is there a way we could take out a mortgage on our house to invest with and get a tax break simultaneously? Al and Muriel Lively, Goffstown, N.H. A. There is a way -- a home-equity loan -- but consider the ramifications. You might decide it is not for you. True, it could provide you with a tax break: all of the interest you pay on a loan of up to $100,000 would be deductible. (If the fair market value of your home minus the amount you still owe on your mortgage comes to less than $100,000, then that lower amount would be your ceiling.) You may use the funds for investments, so long as they do not generate tax-free income. But take care: since you must put your home up as collateral on such a loan, be sure you can handle the payments. A tax deduction won't do you much good if the bank repossesses your house. One critical question: Would the interest deductions you receive on the loan be higher than the standard deduction you would otherwise be entitled to? You say you currently have no tax deductions. This year, if you and your wife file jointly, you can claim a $5,200 standard deduction, possibly as much as $6,400 if you are both 65 or over. In other words, your new deductions will have to be higher than the standard deduction for a home-equity loan to make sense.
Q. I want to sell a restaurant that I inherited. I expect a capital gain of about $100,000. Can I reduce the tax I will owe on the gain by shifting ownership of the restaurant to my three adult daughters? Walter Plewak, North Tonawanda, N.Y. A. You can if you act with care. If the IRS thinks that all you have done is shift income (the gain), it will hit you for the tax on all of it. That would probably happen if you sold the property immediately after transferring shares in the restaurant to your daughters. You should be okay if you make gifts to them of interests in the property, establish a family partnership or corporation that runs the restaurant and in fact holds and operates the restaurant for a period of time -- unfortunately, there is no specified period or objective test on this. Then the income and losses as well as the gain on the sale of the property may be safely divided among you and your daughters. You can take advantage of your annual gift-tax exclusion and give a $10,000 interest in the restaurant to each child each year, free of gift tax, and use a portion of your unified credit of $600,000 as well to speed up the shift.
Q. My wife and I are planning to sell our home. We intend to take advantage of the one-shot tax break that allows people who are at least 55 years old to exclude up to $125,000 in gains on the sale of their primary residence. Then we want to move into a rental property that we own and establish that as our primary residence. Could we then sell it, buy another home of equal or greater value and defer taxes on the sale indefinitely? William L. Krueger, Minnetonka, Minn. A. Your plan sounds fine. Once you move into your rental property and it becomes your principal residence, you may indeed sell it and roll over your gain on that sale into a new home (which will in turn become your new principal residence) as long as you do it within two years of the sale. That way you will continue to defer paying that capital-gains tax. In fact, the law does not give you a choice. You must roll over and defer your gain. One planning point: bear in mind that you may use the $125,000 exclusion only once. So if the gain on your existing home is going to be, say, only $15,000 and you anticipate a much greater gain on the rental property, you might want to save the exclusion for that sale. If you do, be sure you live in the rental property at least three out of five years in order to have it qualify for the exclusion.
Q. If I move out of the state where my muni bonds are issued, will I have to start paying state tax on them? Russell P. Charest, Northampton, Mass. A. They will still be federally tax-free, but most states tax bonds that are issued by other states. So unless you move to one of the seven states with no income tax, you will have to report the income from the bonds on the appropriate state tax form and pay the tax on it.