The Truth About Negative Amortization

DEAR HAROLD: Anything can, and frequently does, happen in divorces. If you signed an irrevocable deed, you can't get the title to your house back. But the valuation of the house in the divorce settlement will be decreased from fair market value because of your life estate. However, the court will surely consider the daughter-in-law's remainder share of the house in the divorce settlement.

DEAR BOB: Last year, my wife and I lent our daughter and son-in-law money they needed to buy their first home. We weren't earning much on the money, and they offered to pay us 5 percent interest. It was a good deal for them and a good deal for us. They faithfully pay us the monthly interest and principal. However, when they had their income taxes prepared, their tax adviser told them that the approximately $32,000 of interest they paid us in 2005 is not tax-deductible because it is an unsecured loan, which is not recorded against their title. Please tell us this isn't true. -- Gregg G.

DEAR GREGG: Their tax adviser is correct. For your daughter and son-in-law to deduct the interest paid to you as itemized home mortgage interest, the loan obligation must be secured by a recorded mortgage or deed of trust against their home. Although you and your wife must report on your tax returns the interest income received, the borrowers are not entitled to deduct it as home mortgage interest because the loan isn't secured by their residence. However, this can be corrected for 2006 by their signing and recording a mortgage or deed of trust to secure the promissory note they gave you.

DEAR BOB: About a year ago, my husband and I refinanced our $375,000 home mortgage to a 5.5 percent interest loan. Now we are in a financial position to pay off our mortgage in full. But our CPA son-in-law advises against doing so. He says we need every tax deduction we can get. However, I would like to be free of the monthly mortgage payments. What do you advise? -- Amy T.

DEAR AMY: Listen to your smart son-in-law. Unless you are in a very low-income tax bracket, your after-tax mortgage interest rate is only about 3.5 percent. That's a true bargain. Surely you can find a safe place to invest that $375,000 to earn more than 3.5 percent interest. Then you will have that money available for an emergency or investment opportunity. Another consideration is if your mortgage has a prepayment penalty. If it does, that settles the matter in favor of not paying off your mortgage.

DEAR BOB: My friend and I have a disagreement about Internal Revenue Code 121. How long must my wife and I own our primary home to avoid tax on our capital gain up to $500,000? We purchased our home in July 2003. Can we sell it now and avoid tax on the gain up to $500,000? -- Richard W.

DEAR RICHARD: To qualify for up to $500,000 tax-free principal-residence-sale capital gains, you and your wife must own and occupy your home at least 24 of the 60 months before its sale and file a joint tax return in the year of sale. However, if you acquired the residence in an Internal Revenue Code 1031 tax-deferred exchange, you must own it at least 60 months to qualify with the same 24-month occupancy requirement.

DEAR BOB: In 1993, my wife's father died. He left everything to her in his will. There are no siblings or other close relatives. Knowing she inherited the house, we moved our family in and have been living in the house and paying its mortgage ever since. Now that our kids are grown and on their own, we want to sell the house and downsize for our retirement years ahead. However, when we talked with a real estate agent about listing the house for sale, she said we can't sell it until my father-in-law's estate is probated and the house title is transferred to my wife. Is there any way to avoid probate? -- Jerome W.

DEAR JEROME: No. However, many states have speedy small-estate probate procedures for situations like yours. Because your late father-in-law willed his house, probate court proceedings are usually required.

Probate could have been avoided if he held title in his revocable living trust, specifying that after his death the house should go to your wife. However, it's too late for that.

I suggest that your wife consult an experienced local probate lawyer to probate the will. Probate lawyers usually can expedite uncontested probate matters so that they take less than the six to 12 months usually required.

But your wife has another problem to consider. When she receives the title, she will receive a new stepped-up basis to market value in 1993. Since then, the house has probably greatly appreciated in market value.