Complicated Tax Question.....help?
In December of 2002, I sold a single family home on a land contract for which I hold the deed. Prior to 2002, namely March of 2000 through December of 2002, I rented the property out. Prior to that, namely July of 1999 through March of 2000, I lived in the home. Upon selling the property, I elected through the advice of my CPA, to pay all of the depreciation recapture and capital gains on the property in tax year 2002.....
In March of this year, 2003, I got scared of the due on sale clause associated with the mortgage I originally took out on the property. That note was a 30-year mortgage with a 7.25% rate and PMI. Since I had no property to secure against a refinance or first mortgage, my gracious father worked out a deal where he secured a 15-year note at 6.49% for the balance of mine with his home under a second mortgage. Since my land contract with the new owners involves a note amortized over 30 years (with a balloon in seven), I have more than enough money to cover dad's payment and pay him a fair return for the "use" of his equity.
After calling the IRS help line, they say that I am unable to deduct the $4500 dollars in interest money that I paid my dad leaving me unsheltered against the almost $9000 I received from the buyers. They also say that even though his property secures the note to me that HE cannot deduct the interest on the 1098 he gets because to quote them: "to take a deduction you must be legally liable for the loan (your relative is the one who pledged collateral and is liable). In essence you paid for his loan. There is no deduction for either you or the relative unfortunately."
This is all contrary to the advice of my lawyer when I went to find an alternative to my original mortgage. Is there some way around this?....perhaps using the (non-farm) business expense avenue since it was a rental property prior to the sale. Why is dad's mortgage interest not deductible....he and I signed a promissary note...can't you deduct second mortgage interest, up to certain limits, for whatever you decide to use the money for? If I had to, could I secure a first mortgage somewhere using the deed to the property, without actually "owning" it? Please help.....
bim94,
Glad to meet you.
I will private message DaveT he if anyone around here can help you with your question.
John $Cash$ Locke
PS: Dave is not on right now but I sent him a private message requesting his assistance.[ Edited by JohnLocke on Date 01/27/2004 ]
bim94,
I am confused on a few points.
1. You said you sold on a land contract, and in the next paragraph you say that you do not have the property to offer as security against a refinance.
If you sold on a land contract, then you should still have title in your name. If you sold on a wrap-around mortgage, then you gave title to your buyer and wrapped your second mortgage note around the first mortgage note.
Which are we talking about here?
2. You said that you paid the depreciation recapture and the capital gains up front. Are you saying that you paid the capital gains taxes in 2002 on your entire profit even though you will receive a lot of your profit in installments?
3. You said that you and your Dad signed a note. Which note is this? Are you saying that both you and your Dad are co-borrowers on a note secured by his property?
Clear up these questions first, then I will have a better idea on how to frame my response.
It is a land contract. The reason I say I don't have property is because the contract is recorded with the county as a sale. The IRS also considers installment sales as "sold", as far as I know.
I do, however hold the title. Right now there is no lein against the property at all since the money my father loaned me came from a note HE secured himself with HIS home, no cosigning. I pay him through a promissary note we signed between us secured by nothing. To simplify things, I just make the payment of his note for him, and pay him a "fee" separately for use of his equity.
Since the gains on the property after recapture were insignificant, rather than drag the gain out over the life of the land contract, I paid all capital gains taxes in 2002. Now as I understand it, the principal portion of my payment is not taxed as regular income and the interest does get taxed as such, with no more capital gains being realized.[ Edited by bim94 on Date 01/27/2004 ]
bim94,
First the disclaimer. Please understand that I am not a lawyer, not a CPA, and not a tax professional. Any information I provide is my personal opinion, intended to be educational, and is not to be considered tax or legal advice. I urge you to consult a licensed tax professional and your own attorney for specific details.
You have two separate tax questions interleaved here and a legal question. Let's break it down and address each separately.
1. Your loan between you and your father. The IRS help line gave you correct information here. You are not allowed to deduct the interest paid on your unsecured note. Your father gave you an unsecured loan, you are repaying it, and the interest you are paying is considered a non-deductible personal expense just as is the interest on all your consumer loans (car loan, credit card, etc). The interest your father receives from you, however, is taxable as ordinary income on his Schedule B.
Remedy: Do you own another investment property, a second home, or even your own primary residence, perhaps? If so, use your other property as collateral for the loan with your father. Record your note and your mortgage, then legally take a mortgage interest deduction for that property.
If you use your primary residence or a second home to secure the note, you must itemize your deductions on Schedule A to take advantage of the deduction. If you can't itemize anyway, then the deduction is lost.
Until you record a mortgage against your property to secure his note, any interest you already paid on your tather's note is still a personal, non-deductible expense.
2. Your father's second mortgage note secured by his property. Perhaps the IRS help line representative did not completely understand your question and you were partially misinformed, or, you were advised correctly but misinterpreted the answer.
Your father has every right to take a home mortgage interest deduction for the second mortgage note secured by his property for the first 100K of his new loan balance. If the second mortgage note was more than 100K then his interest deduction may be limited. I am assuming that the acquisition debt rules are not in play here, and thus, the mortgage interest limitation would apply. Of course, to take the mortgage interest deduction, your father will have to itemize his deductions on Schedule A.
His home mortgage interest deduction (Schedule A) is offset by the unsecured loan interest income (Schedule B), and effectively is washed out. So, I see how the IRS help line representative can tell you that you are paying your father's mortgage interest for which he gets no tax benefit, and, as I explained before, you get no tax deduction.
Call the help line again and ask if your father takes out a loan secured by his property, can he deduct the mortgage interest on his Schedule A regardless of how he uses the proceeds from the loan. I bet you get a different answer than you understood previously.
Your question about whether you can claim the interest you pay your father as a business expense. I ask, for what business purpose? You don't say anything about being engaged in an active business (Schedule C and Schedule SE) so you are just grasping at straws here. Even if you have an active business that you did not mention, your father's loan does not appear to be related to the business at all, so therefore it has no business purpose that would qualify for a business interest expense.
3. I had no property to secure against a refinance or first mortgage. You are still on title to the property you "sold" on land contract -- you still own it. Even though you recorded the contract, I bet you can still place a lien on the property. Talk to a real estate attorney, or a title company, for details. I see the recorded contract as a cloud on the title, but not a hinderance to financing or refinancing. When your contract buyer cashes you out and satisfies your contract, the proceeds will still be used to redeem all recorded liens so you can transfer clear title. Because you said "this is all contrary to my attorney's advice", I wonder if you acted against your attorney's advice, or your attorney misinformed you. If the latter, get a legal opinion from a real estate attorney and a tax opinion from a tax professional. A real real estate attorney is not to be confused with a tax professional.
The IRS says that your land contract is reported on your tax return as an installment sale. This only tells you how to deal with the installment payments you receive, it does not prohibit you from using the property as collateral for a loan.
Thanks for all of the excellent information. Great job.
After speaking to my father abouth the subject, he seems unworried. He is not at all concerned about taking the deduction, and apparently rightfully so. He suggests that when filing taxes, that he just ask his CPA what benefit the interest on the second mortgage contributed toward his return, and credit me that difference. This seems logical to me because his income and mine are similar (for tax bracket benefits). However, I am not looking to pull any fast ones. I just want my dad protected, and not to take a beating on the land contract. BTW....collection of the land contract has been going very well...I would recommend the whole process.
Just for info's sake, are there any financing programs out there where the lender would be willing to offer an attractive package for notes when the property is already sold on land contract? Or since my dad is confident in what we have, should I leave the 15-yr fixed 6.49% alone until the balloon comes up on my land contract in 6 years?
Thanks again
P.S. On the question of grasping at straws to claim a business deduction, I currently own two duplexes and itemize for those. Thought maybe that would be relavent. But, from reading other posts I assume that since that profit/loss is from a passive activity that the deduction in this case would not apply. Also, I do not really want to tie my rental property mortgages to anything related to the land contract.[ Edited by bim94 on Date 01/28/2004 ]
Quote:I currently own two duplexes and itemize for those. Thought maybe that would be relavent. But, from reading other posts I assume that since that profit/loss is from a passive activity that the deduction in this case would not apply. Also, I do not really want to tie my rental property mortgages to anything related to the land contract.
Let's back up for a moment. You pushed the panic button because you discovered that you are not able to take an interest expense deduction for the private loan between you and your father.
I suggested that you use other investment property you own to secure the loan you have with your father and then take a mortgage interest expense against that property.
Right now, your loan with your father is not tied to anything. If you tie it to one of your rental properties, it will have no relationship to the property you sold on contract. Instead, you take the mortgage interest expense on the Schedule E for the property you use to secure the note with your father.
Apparently, you also do not understand my other comments about the interest expense deductions on your father's tax return. The interest he receives from you on your private loan is taxable income, and would be reported on his Schedule B. Your father will have a tax liability for this income. Your father can also take a home mortgage interest deduction on his Schedule A for the second mortgage loan he took out to help you out. You father may have a tax savings from this deduction. The effects of the interest income on Schedule B and the interest deduction on Schedule A should probably cancel each other out (provided he itemizes his deductions). If your father is in a tax neutral position, then he has no net tax savings to give you back as a credit. If your father is not planning to itemize his deductions and can not use the home mortgage interest deduction, the interest income he receives from you will increase his tax liability -- not give him a tax benefit.
In the end if you decide to do nothing, you are still disadvantaged because you can not take an interest deduction for your unsecured loan, and you have no means to partially shelter the $9000 income you are receiving from your land contract.[ Edited by DaveT on Date 01/28/2004 ]