DEAR BOB: Twenty years ago my wife and I bought a two-unit building. We qualified for a bigger mortgage from the rental income and the extra money helped us fix up the building. We lived in one unit and rented the other unit to tenants. Now that our kids are going to college, we want to sell. However, we have been depreciating the rental unit. When we sell, we won’t have to pay capital gain tax on the sale of our personal unit, thanks to that $500,000 principal residence sale exemption. But will we owe taxes on the rental-unit sale? Or can we avoid tax by buying another two-unit building? – Ron R.
DEAR RON: For income tax purposes, the sale of your two-unit rental property is really two separate sales.
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The “first sale” is the value of your principal residence unit, which qualifies for the married couple $500,000 tax exemption of Internal Revenue Code 121. That’s presuming you owned and lived in it at least 24 of the 60 months before its sale.
The “second sale” is the value of the rental unit. Because you have been depreciating that unit, its adjusted cost basis is your original purchase price for that unit, minus total depreciation you deducted over the last 20 years, plus the cost of any capital improvements you added during ownership. This amount is subtracted from your adjusted (net) sales price for the rental unit. The difference is your capital gain.
This capital gain for the rental unit has two parts. One is the total depreciation you deducted after May 7, 1997, which is “recaptured” or taxed at the special federal 25 percent tax rate. The other is pre-May 7, 1997, depreciation, which is taxed at the current low federal capital gains tax rate of 15 percent.
If you want to avoid the capital gain tax on the sale of the rental unit, you can make an Internal Revenue Code 1031(a)(3) Starker tax-deferred exchange for another “like kind” rental or investment property.
The acquired property need not be a two unit building. But it must be of equal or greater cost and equity, as compared to the rental unit being sold. For full details, including the exchange time deadlines, please consult your tax adviser.
WHEN IS REVERSE MORTGAGE INTEREST DEDUCTIBLE?
DEAR BOB: My wife and I have a Financial Freedom Plan reverse mortgage. So far we have taken an initial lump sum cash advance. We also have a substantial line of credit, which we haven’t used yet. Can we deduct the accrued interest on our income tax returns like we did every year with our previous mortgage? If we can’t do that, could we pay the interest each year to Financial Freedom Plan and then deduct the interest? – Wendell F.
DEAR WENDELL: The IRS says interest accrued on a senior citizen reverse mortgage is not tax deductible until the interest is actually paid to the lender. This usually occurs when the reverse mortgage “matures” and is paid in full when the homeowner sells or permanently moves out of the home.
However, if Financial Freedom Plan is willing to accept your annual cash payment of reverse mortgage interest, that payment should qualify for itemized tax deduction on Schedule A of your personal income tax return. For full details, please consult your tax adviser.
MUST NEIGHBOR TRIM A DISEASED TREE?
DEAR BOB: I read with great interest your recent item about responsibility for trimming trees on boundary lines. What about a neighbor’s tree, entirely on his property, which overhangs my house and presents a potential liability problem because it is badly damaged from previous storms? It also looks diseased, of which he is aware. Whose responsibility is it to have the tree trimmed before it causes damage? Will his insurance pay for damage if the tree falls on my house? – Ann C.
DEAR ANN: As you probably know, the general rule is a property owner can trim a neighbor’s overhanging tree back to the boundary line.
But the work must be done carefully because if severe trimming kills the tree, then you would be liable to the neighbor for damaging his tree. Consultation with an arborist is recommended.
However, in your situation where the overhanging tree is diseased and presents a dangerous condition, the neighbor could be found negligent if he fails to trim or remove the tree, which later damages your property.
Your first step is to consult your homeowner’s insurance agent. He or she might wish to write a polite letter to the neighbor explaining the current dangerous situation and that it appears to be negligence if the neighbor doesn’t trim or remove the tree before damage to your property occurs.
If your insurance agent declines to notify the neighbor, then it would be a good idea for you or your attorney to write such a polite letter to the neighbor. The reason for writing the letter is to put the neighbor on notice of the dangerous condition.
Lawyers call this establishing a paper trail. Then, if the tree later damages your property, you have established the neighbor’s negligence so his insurance company should readily pay for any damage to your property. For full details, please consult a local real estate attorney.
The new Robert Bruss special report, “How the New Tax-Deferred Realty Exchange Rules Can Make You Very Wealthy,” is now available for $4 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet download at www.bobbruss.com. Questions for this column are welcome at either address.
(For more information on Bob Bruss publications, visit his
Real Estate Center).
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