The Truth About Negative Amortization

By Robert J. Bruss
Saturday, May 5, 2007

Bruss is away. These questions are taken from previous columns.

Q: DEAR BOB: About a year ago, we bought our home with the help of an adjustable-rate mortgage at 1.95 percent interest. We knew it would adjust after six months to 4.95 percent. That was quite a jump in our monthly payment, but we handled it. However, when we received the lender's Internal Revenue Service 1098 year-end report, we learned our mortgage balance had grown by about $7,800. When I called the lender, I was told the increase was "unpaid interest." What's that? -- Jerry G.

A: DEAR JERRY: The lender should have explained that the 1.95 percent "teaser" interest rate and your current 4.95 percent interest rate don't fully pay the ARM interest rate, which probably adjusts monthly. The unpaid interest you didn't have to pay was added to your mortgage's principal balance each month.

This is called "negative amortization" because you aren't paying the full amount of interest owed to the lender.

The result is that you are not building equity by reducing the mortgage balance, which is growing each month instead of slowly declining as with an amortized mortgage.

Hopefully, your home's market value appreciates faster than your mortgage balance increases. Now you know why I never recommend negative-amortization ARMs.

DEAR BOB: My husband and I have a life estate in a 60-year-old house. We can live in it until we both die. However, the house is not in good condition. It has dry rot, mold and an ant infestation. If I survive my husband, could my husband's daughter have me thrown out for "waste," as you described in a recent column? My husband's family is nice enough to me now, but things could change if he dies first. -- Nancy H.

DEAR NANCY: If the remainderman (your husband's daughter) becomes alarmed at the lack of maintenance of the house, which she will possess after you both die, she can bring a lawsuit for "waste" to terminate the life estate. It is then up to the court to determine whether the life tenant is allowing the house to badly deteriorate and if the life estate should therefore be terminated.

Avoid discussing the condition of the house with the daughter, and do your best to maintain it.

DEAR BOB: My wife and I, in our 70s, are considering a reverse mortgage. We own a free-and-clear condo worth about $500,000. However, it is in a small complex of only three units. We have been told that our unit won't qualify for a reverse mortgage. Is this true? -- Gene B.

DEAR GENE: Consult a representative who handles FHA, Fannie Mae and Financial Freedom Plan reverse mortgages to see whether your situation qualifies with any of these lenders. Generally, Financial Freedom Plan is the most flexible. The best place to find local reverse-mortgage originators is http://www.reversemortgage.org.

DEAR BOB: My fiance and I both own homes. We want to sell his, after meeting the 24-month requirement for ownership and occupancy to qualify for the $500,000 tax exemption. He has lived there about 10 years. Other than being married in the year of the sale, how do I prove two years of occupancy? Must I live there full time? After the two years are over, I would like to move back into my own home. My certified public accountant says I don't have to live there at all. We need the full $500,000 exemption. -- Bonnie T.

DEAR BONNIE: My first suggestion is to fire that CPA for giving bad advice. Your future husband already qualifies for his $250,000 principal-residence-sale exemption from Internal Revenue Code 121 because he owned and occupied his home 24 of the 60 months before its sale.

However, if you are to qualify for an additional $250,000 exemption, you must occupy the home as your principal residence at least 24 of the 60 months before its sale. If you are not married on the date of the sale, then your name must have been on the title at least 24 months to qualify.

But you indicate that you will be married by the date of the sale of his house. In addition to proving your 24 months of occupancy, you must also file a joint tax return in the year of sale.

DEAR BOB: When I die, I want to leave my home to my four adult children. If I take my name off the title and put their names on the it now, will this avoid probate when I die? I can't afford one of those revocable living trusts you recommend. -- Josephine A.

DEAR JOSEPHINE: Your plan could be very bad for you and your adult children. By deeding your house to your children now, you give up control.

For example, suppose your health declines and you need to sell the house to provide funds for your care in an assisted-living or convalescent home. If you give away the house now, you won't have it available to sell when you need its cash proceeds.

Yes, deeding the house to your adult children now avoids the need for its probate after your death. But the gift does a disservice to them because they will take over your presumably low adjusted-cost basis. When they eventually sell your home, they will probably have a substantial capital gain tax to pay.

A simple living trust prepared by a lawyer shouldn't cost more than $1,000, possibly much less. With a living trust, you can maintain control of your home while also providing for avoidance of probate costs and delays when you die.

DEAR BOB: Last August, my fiancee and I bought a house together with equal ownership. Both names are on the title and the mortgage. The lender's IRS 1098 form we received for 2005, however, lists both our names but only her Social Security number, though I am the person who made all the mortgage payments. The bank says they can't change the Social Security number for 2005, but they will do so for 2006. What should I do? -- Lorne C.

DEAR LORNE: Because you paid the 2005 mortgage payments and you are on the title to the house, you are entitled to deduct the mortgage interest you paid (and the property taxes if you also paid them).

Although it is unlikely that the IRS will audit you on this issue, be prepared to show your canceled checks or other evidence of mortgage interest payments. Of course, be sure your fiancee doesn't claim the same interest deduction on her tax returns.

DEAR BOB: About six years ago, I deeded the title to my house to my son and daughter-in-law. Now they are getting a divorce. Although I have a life estate in my house so they can't kick me out, the daughter-in-law wants half the value of my house in the divorce settlement. Is this legal? Can I get my house back? -- Harold V.

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.

However, you and she can't qualify for the Internal Revenue Code 121 principal-residence-sale tax exemption up to $500,000 because she hasn't owned the house at least 24 months (although you both clearly meet the 24-month occupancy test).

DEAR BOB: About five years ago, my aunt died. She left everything to me, including a worthless lot. I consulted several nearby real estate agents, and they wouldn't even list it for sale as it is worth only about $5,000. However, the county keeps sending me property tax bills, which I haven't paid. It has tried to sell the property at a tax sale but nobody will buy it, even for the amount of unpaid property taxes. Now the county reported to the credit bureaus that I owe the unpaid taxes, and this is hurting my credit rating. What can I do? -- Ralph R.

DEAR RALPH: It is unfair for counties to report unpaid property taxes to the credit bureaus, especially when someone inherited worthless property he doesn't want.

Perhaps you can contact the county tax collector to see whether he will accept your quitclaim deed in return for canceling the property taxes. Then you can tell the credit bureaus that the property taxes have been canceled so the adverse information can be removed from your credit reports.

DEAR BOB: I live in a condo complex where one owner has four barking dogs. The neighbor has never walked the dogs and keeps them in a tiny fenced patio. The smell is unbearable in hot weather. The condo homeowner association refuses to act, even though the CC&Rs (covenants, conditions and restrictions) only allow one small pet. What can be done? -- Dorothy J.

DEAR DOROTHY: Shame on your ineffective homeowner association board of directors and officers for refusing to enforce the CC&Rs. However, your city or county health department or the local humane society can take action to abate this nuisance, which is also a health problem. A few phone calls should solve the problem.

DEAR BOB: About six years ago, three of my college fraternity brothers and I agreed to invest in single-family rental houses. They put up the cash, and I managed our six houses, arranged for fix-up and repairs, and obtained tenants. We have done very well. The houses have all appreciated handsomely, and we each get some annual tax deductions, too. All went very well until recently, when one of the "brothers" got married. His wife is not keen on his further investing. In fact, she sweet-talked him into demanding to be bought out. His equity is about $175,000. We can't afford to buy him out without selling or refinancing several houses. Unfortunately, she is a real estate lawyer, and she threatens to sue us for a partition sale if we don't come up with the $175,000. Can she do this? What should we do? -- Jeff R.

DEAR JEFF: Congratulations to you and your fraternity brothers for making such profitable investments. However, you should have had a written partnership agreement to prevent problems like this.

If you hold title as tenants in common, just one co-owner can bring a partition lawsuit to force the sale of all the properties.

The co-owners should have a meeting to resolve the problem before a lawsuit develops. Maybe one or two of the investment rental houses will have to be sold or refinanced to buy out the "bad brother."

Your situation shows why I advise against group real estate investments whenever possible. Sooner or later, especially without a well-drafted partnership agreement, problems usually develop.

DEAR BOB: Almost a year ago, I made the worst mistake of my life. I paid more than $425,000 cash to buy into a relatively new retirement residence. The place looks beautiful, and I like my apartment very much. However, the property is run by a bunch of crooks. They have already raised my monthly fee by $370, and the quality of the service and meals has declined greatly. We are treated like prison inmates. That's almost our situation because there is no way I can sell and get my cash back. Now I know I should have taken the finance option where I could have moved in for as little as $75,000 upfront. You should warn retirees.

-- Lucy R.

DEAR LUCY: Now you know why I do warn against paying all cash for any property, especially a retirement home. The situation you describe shows the risk of paying a large amount of cash for retirement housing, especially a new facility.

Consult a local lawyer who specializes in elder law to see whether you have recourse against the owners of your retirement residence.

DEAR BOB: We plan to sell our home, and want to close by the end of summer. Our niece is a new real estate agent in a town about 25 miles away. She has made only one home sale in her first three months after obtaining her sales license. We would like to help her gain confidence by selling our home. She says she can put our listing into the local multiple listing service. However, friends and neighbors advise against giving her our listing. What do you suggest? -- Helen H.

DEAR HELEN: You have smart friends and neighbors. Listing a home for sale with a relative is always difficult, but it can be especially bad for any home seller to list with a novice out-of-area real estate agent. Putting a listing into the local MLS alone is not enough to get your home sold.

My suggestion is to interview several local real estate agents about listing your home for sale. Include your niece, but also interview two or three successful nearby agents.

Listen to their listing presentations, which should each include a comparative market analysis (CMA) form and written marketing plans for your home.

Compare these valuable CMAs, which will show recent neighborhood home sales prices, the asking prices of nearby homes now listed for sale (your competition) and even recently expired listings that didn't sell. Each agent will include his or her opinion of your home's market value.

Evaluate your niece's listing presentation and her CMA against the other agent CMAs. If she did a good job, I would give her a 30-day trial listing. Explain that you expect her to perform like a champion, performing all the services the other agents promised.

If she gets your home sold within 30 days, that's great. But if she does a terrible job, you lost only 30 days and can then list with a better local agent.

Readers with questions should write Robert J. Bruss at 251 Park Rd., Burlingame, Calif. 94010, or contact him via his Web page, http://www.bobbruss.com.

Copyright 2007, Inman News Service