Equity and/or Investment Interest

[Gretel]

Client bought house to fix up and sell again. Mortgage taken out has his residence and the investment property as collateral. The actual equity in his home more than covers the amount of the loan.

I am thinking since both properties are used as collateral I have a choice to either claim as equity interest or add to basis of investment property, whichever is best. It will cover at least two years, so I will need find out what is better for these 2-3 years.

On the other hand I can choose to use the property taxes either as itemized deduction or add to basis on a year by year basis, correct?

[Nashville]

Choices

Gretel, I've often wondered the same thing. Eligible treatment on Schedule A can always "trump" the other choices if so desired.

Option to treat as "investment interest" on 4952 deprives the seller of favorable LTCG treatment when the house is sold, PLUS it is still an itemized deduction, thus it would appear this choice is inferior to conventional interest deduction on Sch A.

Your post does not say this client is "in the business" of flipping houses, so it is safe to assume he is not, and thus the house can be considered an "investment." Perfectly OK to treat construction period interest as part of the basis of the home if we wish to forego Sch A treatment. About property taxes? I haven't heard this was an option, although an election CAN be made at the beginning of the period to do so.

Keep in mind that by rolling these costs into basis you are effectively converting possible LTCG into ordinary income (the exact opposite of what most tax planning seeks to achieve).

[Gretel]

Thanks, Nash. I am glad you are not mad at me for that one stupid post of mine.

I think it is LTCG anyway since house is owned over a year. Your assumption is correct. One time shot at flipping a house, they thought it was sold long ago. They won't do it again.

[Nashville]

Missing the Point

[QUOTE=Gretel;118797]I think it is LTCG anyway since house is owned over a year./QUOTE]

Your vote of confidence appreciated.

I think you've missed the point on my LTCG strategy. The question is not whether a sale would qualify as LTCG, the question is HOW MUCH LTCG income results. Best to perhaps illustrate.

Situation: Over a 3 yr period investment in house is $80,000, another $30,000 in labor and materials. During the same period there is $10,000 in Property Taxes and Interest. Property sells for $140,000 after 3 years.

Scenario 1: Client deducts $10,000 in property taxes and interest as incurred on Sch A, leaving $30,000 in LTCG. The Sch A deductions have been made against client's prevailing tax bracket, whatever it is, effectively deducting against ordinary income. The $10,000 has been deducted against a rate of up to 35%.

Scenario 2: Client capitalizes the $10,000 in taxes and interest and rolls it into the basis of the house. LTCG is now $20,000, and there has never been anything deducted against ordinary income. Instead the $10,000 has been deducted against a maximum rate of 15%.

The difference in the above is that the $10,000 could have been deducted against ordinary income, whereas in Scenario 2 they served only to lower the LTCGains. All other factors being equal, tax planners would rather deductions apply against ordinary income.

There are situations where the above-strategy could backfire, but not if all other factors are equal.

[Gretel]

Yes, I missed the point. Thank you so much for taking the time to illustrate.

The amounts are lower in my client's situation. Under the assumption that the lower Cap.Gain (if capitalized) would keep income in 15% bracket and hence, zero tax on Cap.Gain then it might be better to capitalize, do I have this right? I have to play with the numbers.

If they don't sell in 2011 either, everything will change and only the devil knows what will happen then.

[Snaggletooth]

Could Backfire

Gretel, I think you have the "right", and playing with the numbers could settle the matter if the events are not so far removed from the future that you don't know what happens the year of the sale.

As mentioned before, in spite of the strategy to maximize LTCG, there are situations where this could backfire. One example might be a shift in TOTAL income (LTCG included) where higher capital gains (although at a lower rate) might trigger taxability of social security benefits. Another example might be to shove interest and taxes to a schedule A, only to find out there are not enough other expenses to itemize.

Like you say, you've got to play with the numbers, in particular including the numbers you expect the year of the sale.

[Gretel]

Like you say, you've got to play with the numbers, in particular including the numbers you expect the year of the sale.

I am taking out my crystal ball to find out 1. the year of sale and 2. the tax situation that applies to that year. I will let all of you know what will be since I am sure you all like to do the perfect tax planning

Thanks, Snags, for the additional pointers. My client isn't affected be either but I always like to get a broader picture of possible scenarios.