I need some advice...

[DTS]

A 63-year old client of mine called today and asked my advice about something. I have no clue what to tell her. Maybe, someone here can.

Someone contacted her about refinancing her home/rental units and taking the equity and investing it in a life insurance annuity for her retirement that will pay her about $22,000 a year after the fifth year through the tenth year. At the end of the tenth year, this amount will go to $28,000. She has been told this will be nontaxable. I don't believe this, but I could be wrong.

Would someone explain what this is and what the tax implications of this kind of transaction to me? I am so skeptical about things like this. If additional info is needed, tell me what you need and I'll get it for you.

Thank you,
Dennis

[OldJack]

The someone was probably a life insurance salesman. I wouldn't say its a bad deal without more facts... but most only benefit the salesman and the insurance company. Its probable not taxable as they are probably just giving her back her money.

[jainen]

starting immediately

The salesman is misleading her but not actually lying. This IS a way to turn her real estate equity into retirement income with very little tax. The refinance is of course completely tax-free.

There are probably two annuities. The first one pays little interest but starts returning principal while the second one is accumulating long-term earnings. Earnings are taxable but the payout is mostly principal which is non-taxable and doesn't even add to Social Security modified AGI. There is a life insurance element included so even when the entire principal has been returned there will still be a guaranteed non-taxable death benefit.

It is very difficult to compare this kind of plan to anything else. Certainly the fees will be high, starting with 2% or so for the mortgage, another 1% for the commission, annual maintenance fees, and some outrageous cost for life insurance on a 63-year-old.

He must expect several hundred grand from the refinance. It seems nice to get $22K starting five years from now, but won't the mortgage payments be almost that much, starting immediately?

[Zee]

I saw a similar question on a non-tax related BBS and found it interesting. If the proceeds of a refinance are used to purchase tax-free investments, it appears the mortgage interest loses it's deductibility. I was surprised. As such, it's bothersome that many financial planner's are advocating this approach. In the other situation, a tax-free municipal bond fund was being advocated as the investment. The planner indicated the fund was earning 8% historically. The problem is it was a "junk" bond fund. This is an awfully risky investment for someone tapping equity in their home.

Here's an article I found by another financial planner. He suggests a way to avoid the non-deductibility of the mortgage interest. My guess is the other financial planner is advocating the same type of approach:

Pitfalls to Avoid When Refinancing Your Home
By Ric Edelman
From Inside Personal Finance

When it comes to your home, I want you to carry a big mortgage. Don’t keep the cash in your walls. But, if you get a cash-out refinance, be careful how you use the proceeds, for the IRS may take you to the cleaners if you’re not careful. Here’s why.

Unlike traditional debt, a home mortgage is the cheapest money you can borrow, and for most consumers it’s the only debt that’s tax-deductible. You can probably invest the cash-out proceeds from refinancing and earn a higher return. That’s why I encourage you to take the cash out of the home and invest it. However, this strategy only makes sense if you can obtain an investment return greater than the after-tax cost of the debt. But make sure you...

… avoid these two investments

Uncle Sam realizes that you get a big tax advantage with your home mortgage. To prevent you from getting a "double benefit," there are two types of investments that you can’t buy with mortgage refi proceeds: those that are tax-deferred or tax-free. This means you cannot use your mortgage money to buy tax-deferred annuities or tax-free municipal bonds. The reason: Uncle Sam doesn’t want you to enjoy a tax deduction on the mortgage and then use the money to invest in securities that let you earn interest or profits that aren’t taxable.

But there is a way around it

The key to success with this strategy is your money trail. It’s okay to own variable annuities and muni bonds, even if you have a mortgage, provided that you can show that the money you used to buy these investments didn’t come directly from your mortgage proceeds. In other words, the money used for these investments must come from your earned income or some other source. Otherwise, you’ll lose the tax deduction on your mortgage interest!

Say you have $100,000 in investments and you want to get a new $100,000 mortgage and use the money to buy annuities or munis. You can’t do that, so here’s what to do instead: sell your investments and use that money to buy the annuities or muni bonds. Then, when you get the mortgage proceeds, use that $100,000 to repurchase the investments you’ve sold. This demonstrates that you didn’t use mortgage proceeds to purchase the tax-favored investments. And that’s imperative.

Note: If you have used mortgage proceeds to purchase annuities or muni bonds, talk with your financial advisor right away.

written 1/99 updated 11.29.05

[BOB W]

Maybe.....

........your client should be thinking of using a reverse mortgage. No salesman eating away principle with no benefit to the t/p.

[JON]

Single premium policy

could be that also-than borrowing against it to finance the annuity. If a straight annuity some of the return is taxable-even if it is delayed.

[jainen]

nonsense

>>the money used for these investments must come from your earned income or some other source. Otherwise, you’ll lose the tax deduction on your mortgage interest!<<

This is NONSENSE. $100,000 of qualified home equity debt is deductible regardless of its use. Tracing rules apply to larger amounts and any mortgage on rental/business property. You can't deduct interest on tax-free investment, but tax-deferred is not tax free. (I would like to see someone argue that municipal bond interest is not tax-free for Social Security recipients, but that's another topic.)

[sea-tax]

I would first like to say that I am not concerned with the taxable ramifications of this idea. As a financial planner however this idea of refi the rentals or home and use money to purchase an annuity or any other type of securities is insane and the person suggesting it should be reported to the NASD or SEC.

Think about what this salesman is asking your client to do. Go into debt to finance her retirement. In my state this is considered illegal and you can loose your license faster than you can say what happened? I would personally recommend to your client not and I mean not to refi house to buy annuity . First if it is a variable annuity then there is risk and she can loose money yet still has to pay mortage. If it is a fixed annuity then They will promise her 8% and eventually deliver the min 3%. Still not enough to pay the mortgage.

I hope you understand what I am getting at hear the tax ramifications are not of any importance for the time being , that fact that this slime is trying to convince client to refi to buy annuity needs to be stopped.

[Zee]

Nonsense?

Are you sure? I would have probably also disagreed, until I read the string.

The general rule in Section 163, as it relates to home mortgage interest ("qualified residence interest") is that it's deductible. However, the very end of Section 163 states, "For disallowance of deduction for interest relating to tax-exempt income, see section 1.265(a)(2)." Section 1.265(a)(2) indicates, "In general, no amount shall be allowed as a deduction for interest on any indebtedness incurred or continued to purchase or carry obligations, the interest on which is exempt from tax under subtitle A of the Code..." (It continues with examples of municipal bonds, etc.)

Also, Publication 936, page 4 indicates the following:

"You cannot deduct the home mortgage interest on grandfathered debt or home equity debt if you use the proceeds to buy securities or certificates that produce tax-free income."

http://www.irs.gov/pub/irs-pdf/p936.pdf

I'll let the brighter minds fight this out.

seatax - Yes, the suggestion of using home equity to finance investments by a financial planner is troublesome. These tactics seem to be successful for the planners via seminars being offered almost daily in the Florida area. The risk coupled with the possibility of erroneous tax advice is frightening. Many investor's home is their biggest asset.

[jainen]

just too risky

Annuities are most appropriate for an investor who wants to avoid risk and has substantial assets in low yield CD's or muni bonds, facing retirement in five or ten years. I think of it more as a way to manage existing retirement funds than to increase earnings. In that context, the potential costs are less important than providing liquidity to real estate equity. It might work for rental property, but as sea-tax points out using her home that way is just too risky.

[DTS]

Thank you

I wanted to thank all of you for your wonderful responses to my question. There is a little more understanding on my part now because of them. I really appreciate your help.

I phoned the client and told her of the great clarification you all offered and it appears there may be more to this story than I offered to you originally. I am going to talk to her midday on Monday as she is going to call the fellow who is pushing this deal. At that point, I will have a clearer understanding what she is being told and I will probably have to post again and get a little more input from you.

Until then, thanks again!
Dennis

[Bees Knees]

This is NONSENSE. $100,000 of qualified home equity debt is deductible regardless of its use. Tracing rules apply to larger amounts and any mortgage on rental/business property.

The $100,000 qualified home equity debt rule only applies to your first or second residence. A rental unit is not your first or second residence. Interest tracing rules must apply to the rental portion of the debt, regardless of how much or how little home equity debt you currently have on your first or second residence.