Don't risk more than 20% on real estate down payment

Finances vulnerable to natural disaster, bad investment
By: Robert J. Bruss: Inman News
DEAR BOB: You recently suggested paying no more than a 20 percent cash down payment and never paying all cash for a house or condo. The reason you gave is unforeseen circumstances, such as finding the condo association is broke or you bought near a toxic waste dump. You say if a buyer puts down 20 percent that is all you lose. Are you suggesting the homeowner walk away from the mortgage? – Jack R.

DEAR JACK: No. I didn't suggest a homeowner walk away from his/her mortgage obligation. In most states, a lender who loses money on a foreclosure sale can seek a deficiency judgment against the defaulting homeowner. However, lenders rarely do so because of the expense (unless the defaulting borrower is very wealthy).

The primary reason to make a maximum 20 percent down payment when buying a house or condo is to avoid tying up a major portion of your assets, especially if you are retired. If you are a multizillionaire, be my guest, take the risk, and pay all cash.

Especially when buying a brand-new house or condo, if you pay all cash you could become the "stuckee" if it turns out to be a "bad house" or a "bad condo." A modest 20 percent down payment limits your maximum loss. If all turns out well, you can later pay down your mortgage or refinance.

For example, who do you think suffered the biggest loss in Hurricane Katrina? Was it the New Orleans flooded-out home buyer who recently purchased with a 20 percent down payment? Or was it the homeowner who had no mortgage, no lender-required flood insurance, and lost everything?

Whether your home is vulnerable to hurricanes, tornados, earthquakes, floods, landslides, wildfires or something else, I don't want you to lose everything by buying your home with 100 percent cash, especially if that is most of your reserves.

ARE UP-FRONT REVERSE MORTGAGE FEES TAX-DEDUCTIBLE?

DEAR BOB: As senior citizens, we are thinking of getting a reverse mortgage on our home for extra income. But we wonder if the up-front expenses and interest charged are tax-deductible? – Roberto L.

DEAR ROBERTO: Reverse mortgage up-front expenses, such as the loan fee, as well as accrued interest over the life of the reverse mortgage, are added to your reverse mortgage balance. You don't have to pay these costs out of your pocket.

Because these expenses are not actually "paid," the IRS says they cannot be deducted until the reverse mortgage "matures" and is paid off in full when you eventually sell your home, permanently move out, or die.

More details are in my new special report, "The Whole Truth About Reverse Mortgages for Senior Citizen Homeowners," available for $5 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet PDF delivery at www.bobbruss.com.

IS THE REAL ESTATE "BUBBLE" READY TO BURST?

DEAR BOB: Eight months ago I purchased a single-family rental house with a 5 percent down payment using an ARM (adjustable-rate mortgage). As I read about "real estate bubbles," I worry I should either (a) refinance to a fixed-rate mortgage or (b) sell and take my profits. If I wait five years, I am afraid the home might be worth less than today. What is your opinion? – Max B.

DEAR MAX: Sorry, my crystal ball is very foggy today. If you think your area is in a so-called real estate bubble of peak market values for homes, today would be a great time to sell to take advantage of your short-term profits.

Please be aware the long-term trend of home values has always been up. But there are peaks, valleys and plateaus along the way. However, I don't know of a better long-term investment than sound, well-located single-family houses, do you?

HOW TO CALCULATE HOME-SALE CAPITAL GAIN

DEAR BOB: What is the cost basis for the capital gains exclusion on the sale of a principal residence? Isn't the capital gain the difference between the purchase price (not what is owed) and the selling price? – Elizabeth M.

DEAR ELIZABETH: I am puzzled by your first question. The answer to your second question should help.

The adjusted cost basis for your home (or any property) is its purchase price, plus most non-deductible closing costs, plus capital improvements added during ownership, minus any depreciation deducted (such as for a home office or rental use).

Your adjusted sales price is the gross sales price, minus sales costs such as the real estate sales commission. The difference between these two numbers is your taxable capital gain.

You are correct the mortgage balance is irrelevant.

From your home-sale capital gain, subtract your Internal Revenue Code 121 tax-free principal residence sale exemption up to $250,000 (up to $500,000 for a qualified married couple filing jointly).

That's presuming you owned and lived in the principal residence at least 24 of the 60 months before sale. Any remaining balance is taxable as a capital gain. Your tax adviser has further details.

STEPPED-UP BASIS EASES PROFIT CALCULATION

DEAR BOB: My mother died recently. She left me stock shares. What do I use as the base price for reporting those shares? She received them from my father many years ago – Tom R.

DEAR TOM: Because you inherited those common stock shares, your "stepped-up basis" is their market value on the date of your mother's death. The same principle applies to inherited real estate, which is received by heirs with a new market value "stepped-up basis" on the date of the decedent's death. The purchase price doesn't matter.

If your mother had transferred those stocks as gifts to you before her death, then your basis would have been her stepped-up basis when she received them from your late father.

Real estate gifts received before the owner's death have the same drawback. Thankfully, there is no need for you to determine her stepped-up basis value. For more details, please consult your tax adviser.

LENDER SETS THE RULES ON GETTING RID OF P.M.I.

DEAR BOB: My mortgage lender is unwilling to discuss dropping my $118 monthly PMI (private mortgage insurance) payment until May 2006 when I will have 24 months of ownership. I am willing to pay for an appraisal to prove there is no need for PMI because I now have well over 20 percent equity. But I don't want to sell or refinance. My FICO credit score is 750. Do I have any other recourse than refinancing to get rid of my PMI? – Randy H.

DEAR RANDY: You are the PMI "stuckee" because your mortgage lender gets to set the rules for removing that wasteful $118 monthly PMI premium.

Yes, there is a federal law on this issue. But it won't help you (or any PMI borrower) because it requires the mortgage to be paid below 78 percent of the purchase price.

For most PMI borrowers, that won't happen until at least the 10th year of the mortgage. Increased market value due to capital improvements and market value appreciation doesn't count under the useless federal law.

Now you know why I recommend avoiding PMI whenever possible. Unless you are willing to refinance with another lender who doesn't require PMI, you will just have to wait until you meet the lender's nonsense 24-month requirement in May 2006.

PROS AND CONS OF A REVERSE TAX-DEFERRED EXCHANGE

DEAR BOB: I found a property for rental investment that I want to buy and exchange. But I have not yet sold my rental unit. Can I do a "reverse mortgage" in a Starker exchange? What happens to the money received when my rental property sells? – Beverly C.

DEAR BEVERLY: Yes, you can do a tax-deferred "reverse exchange" by acquiring the replacement investment property before selling your current investment or business property.

However, title must be taken in the name of a qualified third-party accommodator, using your money. Unless you are very wealthy with lots of cash sitting around the house, you might be better off tying up the replacement property with an option, or a lease-option, to give you time to first sell your current rental property. For details, please consult your tax adviser.

NO WAY TO AVOID CAPITAL GAIN TAX ON THIS HOME SALE

DEAR BOB: I have lived in my home less than a year. But I wish to sell it to build a new home. Isn't there some way around the capital gain tax? I heard you can invest the gain to avoid the tax? – Dana C.

DEAR DANA: Sorry. The old "residence replacement rule" of repealed Internal Revenue Code 1034 was abolished in 1997.

If the reason for selling your principal residence after less than 12 months of ownership is to build a new house, your long-term capital gain will be taxed at the 15 percent maximum federal tax rate, plus any applicable state tax.

However, if the reason for your home sale is a job transfer qualifying for the moving cost tax deduction, unemployment, divorce, health reasons, or other "unexpected circumstances," you might be eligible for a partial Internal Revenue Code 121 principal residence sale exemption. Your tax adviser has details.

The brand-new Robert Bruss special report, "24 Key Questions: Living Trust Secrets Reveal How to Avoid Probate Costs and Delays," is now available for $5 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet PDF delivery at www.bobbruss.com. Questions for this column are welcome at either address.