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Dangers of downsizing to cut debt

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POSTED June 7, 2012 7:26 p.m.

DEAR BENNY: I am 58 years old and married. My total household income is less than $50,000. I have no mortgage; however, I do have a line of credit with $130,000 owed.

I have a daughter who is a junior away at college. I want to help pay for student loans once she graduates. Do you think I should put my house up for sale and downsize to maybe a condo or townhouse? My home is probably worth about $250,000 in this market. I am worried that I will never be able to retire. What do you think? --Rod

DEAR ROD: I cannot give specific legal or financial advice, but have some general observations. What is the benefit of downsizing? Your house is free and clear, so your only obligation is to pay the yearly insurance premium and the real estate tax. Of course, there is maintenance and upkeep that has to be considered.

Let's assume you can get $250,000 when you sell your house. If you use a real estate agent, you will have to pay a commission, which could range from $12,500 to $15,000. You could try to sell it yourself and save the commission, but you really have to know what you are doing.

Your potential buyer may want concessions from you, such as paying closing costs, or a cash credit at settlement (called escrow in the Western part of the country).

So, bottom line, even if you get the full asking price, after paying off your home equity loan, you will net somewhere in the neighborhood of $100,000. The good news is that if you have lived in the house for two years out of the five years before it is sold, you can exclude up to $250,000 on any gain; or if you are married and file a joint tax return, you can exclude up to $500,000. So, with the price of $250,000, if you meet the use and ownership tests, you will not have to pay any capital gains tax.

Then what? What can you buy that will compare to your present house for $100,000? And actually, with closing costs, you will have to buy something for even less than $100,000.

Bottom line: If you do the math, you will end up worse if you try to downsize. You are blessed with a house that is free and clear. Hopefully, in the years to come, your house will appreciate in value, in which case you may be able to get a higher home equity loan.

Helping your daughter pay her student loans is admirable, but you have to think about your own situation. And besides, Congress is actively looking to curtail student loan interest expenses. Even with its current dysfunctional state, there may be a compromise enacted before the November elections.

My advice: Enjoy your house.

DEAR BENNY: Our two adult children each own a primary residence and now jointly own two rental homes. This places them as holders of three properties each.

They purchased the second rental home last year and we fear that they may not be able to deduct the mortgage payments and other expenses on this property on their federal tax returns. Additionally, if they eventually have to sell it at a loss in the future, the loss may not be deductible either.

Should they place the third property in an LLC or other legal device? --Frank

DEAR FRANK: You really have asked two separate questions: (1) Will they be able to take tax benefits from the third property? and (2) Should they put the property into a limited liability company (LLC)?

As for the first question, I can provide only general information; for specific answers you (or your children) should consult a tax adviser. In general, just because one has several investment properties does not preclude them from taking interest deductions or claiming loss when the property is sold. Of course, if they use one of the properties as a second home, it may lose its status as "investment." Additionally, if this is a vacation home that is rented out for periods of time, the tax laws differ based on how long the rentals are.

Bottom line on this first question: Your children have a number of investment properties and they really should have a tax adviser who can assist and guide them and of course prepare their tax returns at the end of each year. The accountant's fee is, in general, also a tax-deductible expense.

As for the second question -- whether to place the property into an LLC -- it is my personal opinion that investment properties should be in title in a limited liability company. Why? Because if you follow the rules for an LLC (i.e., you do not commingle funds, and all documents are signed in your capacity as member or manager of the LLC and not in your individual name), you insulate all of your other assets.

For example, your children have three properties. If a tenant sues claiming health-related injuries due to mold, and if there is a very large judgment issued by a jury, all of their assets can be attached and sold in order to satisfy the judgment. But if the property is in an LLC, then only the equity in that property can be attached.

I recognize that some investors -- especially in California -- have written to complain that the cost of creating the LLC is just not worth the effort. Those investors have argued that so long as they have adequate insurance coverage, it is not necessary to go through the hassle of creating an LLC and then transferring the property into that LLC. In fact, in many states, there is a steep recordation and transfer tax if you transfer property into an LLC as compared to putting it in the LLC when you first buy the property.

So, once again, the answer to your second question depends, in large part, on your state law. Your legal and tax advisers should be able to give you the specific answers you need.

DEAR BENNY: What can I do when my lender refuses to work with me? I have tried to work something out with them and they flat out refused. I had equity in my home and it was never underwater. I tried to get a loan modification, but that didn't work either! What can I do? --Joe

DEAR JOE: I need more information as to why your loan application was denied? Was it because of your financial status (i.e., FICO score too low)? Was it because the loan-to-value ratio did not work? Or are you in a condominium where FHA has imposed very strict loan requirements?

Is your lender included in the recent mortgage settlement? If so, you may be able to get some relief. Alternatively, don't just stick with one potential lender; shop around. You may find an aggressive lender who will be willing to work with you, assuming of course that you can qualify.

We have to understand and recognize that even though mortgage interest rates are at an all-time low, lenders have been burned badly as a result of the mortgage meltdown, which has yet to rebound. And even though to a large extent the meltdown was created by those same mortgage lenders, the restrictions and requirements nowadays for getting just a simple loan are mind-boggling.

For example, a reader wrote me that the potential lender required a copy of a bank statement; the reader sent only the first page of the statement, as the second page was just consumer information about the bank. Nevertheless, the lender demanded the entire document or the loan would not go through.

Finally, your state may have some assistance programs, but if you are not underwater, you are low on the priority lists.

Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

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