Author Topic: Purchase from fiancee creates acquisition debt for mortgage interest deduction?  (Read 7128 times)

curiousgeorge

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My fiancee inherited a nice portfolio of free and clear residential rental properties, which include our current home.  She is locking up those assets and the gains on those assets forever with a prenuptial agreement. I'm a working slob that can likely qualify for a sizable mortgage loan on my own, and I'd like to avoid working until I die.  My idea is that I buy our home from her outright (or a portion of the house) to tap into the tax benefits of home ownership as well as release the equity in the home.  Then, the proceeds along with my own cash (and a loan from my retirement account) can be used to expand the current real estate portfolio as the cash downpayment or outright purchase of a rental property, but I would be granted partial ownership in this new property.  I would have to at least partially own our home for the tax deduction but my handshake promise to her would be that she would get the house in case the marriage failed.  My intent would be to have all or a portion of the revenue stream from the investment property pay for the resulting mortgage, and I've identified several opportunities that would be cash flow positive.  Effectively, I would think of the mortgage as the financing tool for the investment property. I may just pursue a rental property purchase on my own directly, but it seems like a waste to not leverage the equity, historically low interest rates, and the tax benefits of doing something like the structure above. 

The key issue is to capture the home mortgage interest deduction, the higher caps require the debt come from acquisition debt.  Does the purchase from my fiance somehow disqualify this as acquisition debt? Would getting married then disallow this as acquistion debt?

My fiancee is concerned that my idea is "illegal" or unethical in some way and is generally less motivated to "expand her empire" anyway since she is already set for life. My goal is to start building for my own future, especially in the event of divorce, with passive income tools while leveraging the tax benefits that come with mortgages.

Any thoughts?  Is this idea silly?  Is it "illegal"?  I've convinced myself that this could work well, but I'm happy to have someone explain to me that I'm wrong.

Credaholic

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There's nothing illegal about obtaining a loan on a property with free equity in it and then using that money as the down payment on a rental property, or to purchase outright. I don't think you'll get a higher cap on the property though by acquiring it. The bank is definitely going to do their own appraisal and possibly be a little stingier with their valuation of your property because it isn't an on the market sale. This is going to be the case whether she obtained a loan on her property, or you obtained one having recently purchased it from her, because the property wasn't listed on the open market.

You can either purchase the house from your fiance and finance it yourself, in which case she would have to pay sales tax on the sale of the home, or what would make more sense in my mind is to quit claim you onto title after you're married which you can now do sales tax free since you are husband and wife. At that point you'd then have the right to get a loan on the property, although if you were doing it in just your name she would have to sign something agreeing to let you do so since the loan puts her position in the property at risk.

To take a partial interest in the property before marriage and try to obtain financing on your partial interest greatly complicates things. I'm not entirely sure how this works with financing since it's a much more unusual situation, but I know that most banks aren't going to want to lend on a 50% interest in a house because foreclosing on the property and trying to recover those assets if you defaulted on the loan would be hard. It also sounds like your fiancee is making sure to protect the assets she's been given, so I think it would be unlikely that she'd be interested in putting half of her house at risk.

If you're in a position to afford a mortgage and buy a home, I think your options here are to buy your own home (as a rental of course) totally separately. Or, if for financing reasons (like a lower rate) it is cheaper to tap into the equity in the house you're living in, quit claim yourself onto the property once you're married and put your wife on title of the rental that you subsequently buy so that the risk she's taking on in mortgaging her home is mitigated by ownership in another rental property. The other option would be to ask your fiance for a loan - have her tap into the equity of the home herself, use that money to buy a rental (or rentals) that again you'd probably want to put both names on for her security, and have a handshake deal whereby you pay the mortgage.

curiousgeorge

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My reading of the mortgage interest deduction allows for loan sizes up to $1,000,000 that can be deducted when the debt was for acquisition.  Home equity loans are limited to $100,000.  In our area, it is pretty easy to get more than halfway to $1M, even with a conservative value on the home. 

Credaholic

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I definitely need to eat a slice of humble pie because for all of my real estate/finance knowledge, I had no idea that interest deduction on HELOCs was limited! I guess I've never been lucky enough to have that much free, financeable equity in my real estate...

But yes, it looks like you're exactly right, it has to be acquisition debt (or used for improvements) to be a write off over $100K. I still say that there is nothing illegal about buying the house from your fiance and obtaining a loan to do so, however I do think that is more convoluted than necessary since if you could afford to do this, you might as well simply purchase the rental you're interested in owning, and your fiance would be subject to taxes due to the sale.

dragoncar

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I really think you should just ask your accountant/tax attorney.  Are the lawyers working on the prenup capable in tax law?  You'll probably benefit from professional help anyways with "a portfolio of rental properties."  edit: it might end up being beneficial to hold properties in an LLC or something more complicated

kite

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Legal -- probably.
Advisable?  No. 

Your stated goal is not to work forever.  But your method for financing a purchase of a home you don't need is to borrow from your retirement funds; which in turn will require you to work even longer.  If you needed to buy a home, that would be one thing.  But you don't need to buy one.  The motivation to buy shouldn't be to get the tax deduction.  It should be because you need a home, you'll be staying put for a very long time, and it is more cost effective to purchase instead of rent. 

Have your own attorney review that pre-nup.  In my state, a spouse has a claim on the marital home, even if their name is not on the property.  I own real-estate that I purchased independent of my spouse.  There have never been any issues between us and after a few decades together, none are expected.  But it always comes up from lenders with regard to financing on that property.  Since I'm married and his name isn't on the title. -- I need to either have his signature or otherwise prove that it isn't HIS primary residence.   The intent of the law is to protect an innocent and unknowing spouse from having their home ripped out from under them.   Your attorney, in your state, reviewing the pre-nup you are about to sign, can advise you of your rights.


Daleth

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Legal -- probably.
Advisable?  No. 

Your stated goal is not to work forever.  But your method for financing a purchase of a home you don't need is to borrow from your retirement funds; which in turn will require you to work even longer.  If you needed to buy a home, that would be one thing.  But you don't need to buy one.  The motivation to buy shouldn't be to get the tax deduction.  It should be because you need a home, you'll be staying put for a very long time, and it is more cost effective to purchase instead of rent. 

Yeah, I have to agree. If you're going to borrow money to buy real estate, just get a mortgage or two to buy some rental properties of your own. Especially since you two have an agreement that she would get this home if you split up, why would you want to invest all your money in this home?

And this just doesn't seem right or fair to me:

Then, the proceeds along with my own cash (and a loan from my retirement account) can be used to expand the current real estate portfolio as the cash downpayment or outright purchase of a rental property, but I would be granted partial ownership in this new property.

If you buy her house (that you both live in) or some portion of it, and then "the proceeds" of that sale (i.e. the money you gave her to buy into the house) are combined with YOUR cash and YOUR retirement loan to buy a new rental property... uh, why would you only get PARTIAL ownership of that new rental property? It was bought entirely with YOUR money.

Some couples do keep their assets separate, with prenups or otherwise, and it works just fine. If you're going to do that--which obviously you are, since you're doing a prenup--it needs to go both ways in order to be fair. In other words, since she is keeping her rental properties separate from you (fair enough, since you didn't help her buy them), then you need to keep at least some of your investments bought with your own money separate from her. In your shoes I would buy a rental property or two in my own name before the marriage and add them to the prenup to clarify that they are yours in the event of separation.

If you don't have time to do that before getting married, talk to the lawyer you've been working with for the prenup (you should have your own lawyer for this, and she should have her own lawyer*) and ask how else you can protect at least some of your investments. Maybe there's such a thing as a "postnup" in your state, or maybe if you put the money for the houses in a separate account before the wedding and can prove all the money to buy them came from there, that might make them yours in the event of a separation.

* Depending on your state's laws, the prenup might be invalid or at least vulnerable to being ignored by a divorce court if you didn't have your own lawyer look over it and advise you.

kite

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 In your shoes I would buy a rental property or two in my own name before the marriage and add them to the prenup to clarify that they are yours in the event of separation.


I purposefully left this out.
One should buy rental property because one wants to be a landlord and has the cash or the ready financing to buy the right property.
The OP's proposed financing includes a loan from retirement account.  That's a pretty good indicator that it's a bad move.  It sounds to me like he's trying to play catch up. 

If she inherited a fancy car, would we encourage him to go finance one just so he had one in his name?
If she inherited a stable full of horses, would we encourage him to go into debt to buy his own stallion and a few mares?
What she inherited is an asset that isn't very liquid.  The wisest move for them as a couple may be to balance that with very liquid assets.  He should put out of his mind that he is missing out on something by not having a mortgage interest deduction.  Tax deductions are not enough reason to take on debt. 


electriceagle

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What is the point of "capturing" the mortgage interest deduction when she is going to have to pay taxes on that same interest?

It sounds to me like:
1) She wants to keep her properties separate in the marriage (which is totally fine)
2) She wants you to pay for half of the house that you will live in together

If this is the case, you should own half the house if you pay for half of the house. If you two split up, one of you should buy the other out, rent half the house to the other person or otherwise make the other person whole.

I don't think that the part about using your payment for the house to buy rental property and having that rental property pay the mortgage works out. If you want to buy rental property with a return that will pay the mortgage, do so separately.

curiousgeorge

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Thanks for the interesting replies. 

Let me try again, because I think it is pretty straightforward.  I'll even use some simplified nominal numbers as placeholders to make it more concrete. Remember, my goal is not to buy her house.  My goal is to buy an interest in a property that produces income.

Suppose I purchase her property for 600000.  For simplicity, let's say it is 90% LTV at 4.125% annual rate fixed for 30 years.   I hold a mortgage that has a balance of $540,000 with monthly payments of $2617.11.  Since the property was acquired via this mortgage, the interest on this loan is tax deductible.

Now, we go forward to purchase an income producing property.  Remember that she already manages about 50 units and has extensive understanding of the rental laws and procedures and also has contacts with maintenance folks.  By adding me to the mix, we have another person to manage and respond to the needs of the property as well as another interested party in studying the laws, contracts, interested tenants, etc.

Suppose the purchase price is 1,500,000.   The 600,000 in liquidity produced by the home purchase provides a healthy down payment.  The balance (900,000) is financed at 4.25% for 30 years, resulting in monthly payments of $4,427.46.

Let's say the income property can be expected to produce $85,000 net of expenses (maintenance, property tax, vacancy) annually.  Not a slam dunk, but not bad for the area.

Now, the annual payments for the two loans comes to $31,405.30 and $53,129.51 for a total of $84,534.81.

In this case, the entire transaction (financing the house, financing the income property, collecting rents, paying expenses) is roughly cash flow neutral.

However, in year one, the total interest payment on the mortgage loan come to $22,100.39, reducing our tax burden by roughly 28% of that ($6188).  This benefit only happens because of the effort put into structuring in an acquisition loan that is deductible.

Hence, the "cash" on cash return here is 6188/60000= 10.3%

There are other details here, as this structure would show rental income that would be subject to tax.  However, the depreciation deduction would more than wipe that out (1/27 of 1,500,000 is $55,555), producing another tax benefit and more gain on the cash investment.

Granted, I think assigning ownership here is complex, because I'm assuming that I alone would pour in the $60,000 in the beginning that gets this rolling, but she would be putting her home at risk in the process, and I would be attaching myself to a home mortgage.    But, we've essentially added a property to the portfolio that returns 10.3% on cash in the first year.  In thirty years, we would hope that the property is cranking out at least $85K per year in rents with no more financing costs, and the original home will also have been paid for and we are still happily living there. 

Thoughts?







electriceagle

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Hi Curiousgeorge,

The general plan does make more sense now.

Simplified, you are relying on a good return from a rental property to pay the costs of the rental property and your own housing costs. The reason for not just going out and buying a rental property with a mortgage is that the loan  terms are better for owner-occupied housing. (Most people get around this by buying a 2-4 unit building and occupying one unit themselves, at least for a couple of years.)

It sounds like your risk is in two places:
1) The return from the rental property - will you really get what you expect?
2) The ownership structure, if you wind up owning just a portion of the rental property. Minority ownership can be complicated because the majority owner has control and can dilute, require extensive pay-in, self-deal, etc.

The plan doesn't seem half bad. On the other hand, the standard way of getting rental income while taking advantage of owner-occupied loan terms is to buy a 2-4 unit building and live in one unit. Would she be willing to do that?

curiousgeorge

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The plan doesn't seem half bad. On the other hand, the standard way of getting rental income while taking advantage of owner-occupied loan terms is to buy a 2-4 unit building and live in one unit. Would she be willing to do that?

This is where the disconnect in our relative wealth causes a challenge.  Certainly, I myself would be all for doing something like that or even more aggressive solutions.  For starters, I certainly would "consume less" housing myself.   In fact, her father used even more aggressive strategies in building his wealth, such as renting out rooms or the basement of his house.  However, given her condition, she is not really motivated to live in one unit of a rental building or even consider more aggressive downgrades in housing quality.  She has already won the game, and I have to keep playing.  I'm trying to find a middle ground.

I think she would be open to something like this if she knew that it wasn't "illlegal" or "unethical", it was at least cash flow neutral, and I had some skin in the game. 

Fishingmn

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Still think the previous recommendation of running this by the lawyer - specifically the lawyer writing her pre-nup - is the place to start. My guess is that they will highly discourage this plan.

I wouldn't "borrow" from retirement account unless it was free. There are certainly some self directed IRA's which would allow you to put money into rental real estate and that can be a very good strategy.

Have you even calculated out the value of getting the mortgage interest deduction? It might be interesting to run tax scenarios to see whether it's really worthwhile. On top of that, there are plenty of discussions in Congress to do away with or reduce it in the future.

Tyler

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IMHO, borrowing from a retirement account in order to accumulate over $2mm in leveraged debt in a complicated legal arrangement qualifies as a moneymaking scheme.  It'll work great until it doesn't.  And when it doesn't, you'll be bankrupt.

dragoncar

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Still think the previous recommendation of running this by the lawyer - specifically the lawyer writing her pre-nup - is the place to start. My guess is that they will highly discourage this plan.

I wouldn't "borrow" from retirement account unless it was free. There are certainly some self directed IRA's which would allow you to put money into rental real estate and that can be a very good strategy.

Have you even calculated out the value of getting the mortgage interest deduction? It might be interesting to run tax scenarios to see whether it's really worthwhile. On top of that, there are plenty of discussions in Congress to do away with or reduce it in the future.

+1 will you really be in the 28% bracket?  Are you sure you won't be subject to amt?

kite

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IMHO, borrowing from a retirement account in order to accumulate over $2mm in leveraged debt in a complicated legal arrangement qualifies as a moneymaking scheme.  It'll work great until it doesn't.  And when it doesn't, you'll be bankrupt.

This. 

And one more thing,  the lawyer drawing up the prenup is not your lawyer.   Don't go to him for advice.   Get your own. 

curiousgeorge

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+1 will you really be in the 28% bracket?  Are you sure you won't be subject to amt?

Could be 33%.  I'm ignorant on AMT.

Daleth

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IMHO, borrowing from a retirement account in order to accumulate over $2mm in leveraged debt in a complicated legal arrangement qualifies as a moneymaking scheme.  It'll work great until it doesn't.  And when it doesn't, you'll be bankrupt.

This. 

And one more thing,  the lawyer drawing up the prenup is not your lawyer.   Don't go to him for advice.   Get your own.

Yes, you need your own lawyer.

Also, when you ran the hypothetical numbers to calculate your cash flow and ROI, I didn't see any numbers for the repayments on your loan from your retirement fund. Also, have you asked your employer whether loans are even available (not all employers offer them), and factored in the requirement that you either pay it all off before leaving that employer or take a tax hit on whatever you haven't yet paid off when you leave?

Wile E. Coyote

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My idea is that I buy our home from her outright (or a portion of the house) to tap into the tax benefits of home ownership as well as release the equity in the home. 

Sorry for being a little slow in the uptake here, but if you are buying the house (or a portion of the house) from her, where is there equity being freed up for you to use in real estate?  She is getting the cash that you are borrowing to buy the house (or a portion) and now you have a mortgage that you have to pay and no additional cash.  I am also not sure I follow the tax benefits here as you now are paying mortgage interest, which is of course deductible, but you are still out of pocket the interest.  Why not just take the cash that you both have and invest it in a rental property?  If you need to borrow, then you should be able to write-off the interest expense against the rental income.  Buying the property from her just puts you in the hole and gives her more cash.  If she needs cash to invest, then she can take out a home equity line. I would think that even if the amount borrowed exceeded the amount on which interest would be deductible under the home mortgage interest deduction, I would think it could still be deductible against the rental property if the proceeds of the loan are used for investment in the rental property.

curiousgeorge

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Just to review...
In the nominal example above
The home would be mortgaged at 90% LTV with a balance of 540000.
The income property would be mortgaged at 60% LTV with a balance of 900000. 
Total amount financed is 1,440,000 secured by properties worth 2,100,000 for an overall LTV of 68.5%, which is still fairly conservative.

The income property purchase could certainly be lower or it could even be a bit higher.

Again, tax policy and lenders treat home mortgage loans in a privileged way, so the terms are superior on that loan.  Now, when considering the loan on the income property, bringing 40% cash down brings better terms on that loan as well. As mentioned, the depreciation deduction allowable on the income property is already more than enough to show a paper loss there.

The maximum income property I could purchase directly with 60,000 is 300,000, and that is probably a stretch.  The terms would be inferior. Certainly this is possible, but it would preclude buying a multi-unit building in the area commensurate with the existing portfolio, so the business operation wouldn't be as good of a match.  And the leverage in this case would be 80% LTV, worse leverage on a smaller deal.

I'm aware of the terms, rules, rate, etc of loans against my retirement account and didn't want to include it in the example because I thought it was a distraction from the question I was asking.  The objection to using this as a source are duly noted.

Wile E. Coyote

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Sorry, my question was a bit more basic than that. If you buy the house from her for 600k and finance 90%, then she now has 600k and you have 60k oh equity I'm the house. How does that help you then invest 600k in an investment property?  I can understand how she could as she now has 600k in cash. What I seem to be missing is how you are contributing to this investment. It seems that you now just have a highly leveraged home.

curiousgeorge

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Sorry, my question was a bit more basic than that. If you buy the house from her for 600k and finance 90%, then she now has 600k and you have 60k oh equity I'm the house. How does that help you then invest 600k in an investment property?  I can understand how she could as she now has 600k in cash. What I seem to be missing is how you are contributing to this investment. It seems that you now just have a highly leveraged home.

Well, in your characterization, she gets to live in this home, right?  This is a house that she wants to live in and that she wants me to live in.  That seems to be a significant contribution to the marriage.  The investment income would more than cover the costs of the now financed house.  I'm also contributing the event that triggered the acquisition debt that allows for the mortgage interest deduction, and the income capacity to quality for the mortgage.  Clearly my interest in the investment property would be reflected in the debt on the house.

If we were to divorce, I'd swap the debt in the house for the debt in the investment property and she would have her house back.

Wile E. Coyote

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Sorry, again I seem to not be communicating well. I  sure you are more than contributing to the relationship, etc. I was referring to assets being contributed to the investment. Is she going to gift you the cash?  Loan it to you?  Will she invest the money and transfer part ownership in the investment to you?  Are you contributing services and receiving an interest in the investment in return? 

tomsang

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Curiousgeorge- I like your thinking.  Get her to use seperate property to buy community property so that you have a stake in it.  Am I missing something or is she putting up all the capital and you are splitting the rewards?  She also has the experience to manage the rentals.  So she will be doing the work, putting up the capital and splitting the appreciation/income with you.  It must be true love!  I would think that her prenup attorney will have some choice words to say about doing that transaction. 

Why couldn't she just do all of this with her seperate property and have her keep all of the appreciation and income protected from you?

If you can get away with it go for it.  The more you taint her assets the bigger the claim you have for everything.

Tom

kite

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If we were to divorce, I'd swap the debt in the house for the debt in the investment property and she would have her house back.

That's so romantic.  Maybe your jeweler could engrave it inside your rings.

curiousgeorge

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Curiousgeorge- I like your thinking.  Get her to use seperate property to buy community property so that you have a stake in it.  Am I missing something or is she putting up all the capital and you are splitting the rewards?  She also has the experience to manage the rentals.  So she will be doing the work, putting up the capital and splitting the appreciation/income with you.  It must be true love!  I would think that her prenup attorney will have some choice words to say about doing that transaction. 

Why couldn't she just do all of this with her seperate property and have her keep all of the appreciation and income protected from you?

If you can get away with it go for it.  The more you taint her assets the bigger the claim you have for everything.

Tom

Tough crowd here.  Thanks for the thoughts.

curiousgeorge

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Just to make a clean exit, I'm dropping this direction.  Thanks for the thoughts.