gaming the mortgage interest deduction

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TinkerPDX
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gaming the mortgage interest deduction

Postby TinkerPDX » Sun Jul 16, 2017 10:22 am

We are preparing to purchase a home from my in-laws, and they will owner-finance.

It occurred to me that the payments to them over the term of the mortgage could be identical for different combinations of purchase price and interest rate -- i.e., we could purchase it for X at Y%, or at some price<X, and rate>Y, and they would still receive the same monthly payment and the same total amount. Meanwhile, we'd have more mortgage interest to deduct (assuming that deduction remains / remains meaningful).

Is there some IRS rule preventing/limiting gaming the deduction this way? It seems like there must be, but I can't find it. In this case, the rate they would be willing to give us is probably lower than the rate we'd get on the market, so to the extent it's about transactions being arms-length/etc., there's at least a little wiggle room.

Appreciate anyone who can point me toward an answer.

(I'm going to engage an accountant and/or lawyer on this - there's also going to be a granny flat in the back that we'll lease back to them, so more tax planning potential - but I'm trying to figure out whether this first concept is just a non-starter before I get into getting professional advice.)

ResearchMed
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Re: gaming the mortgage interest deduction

Postby ResearchMed » Sun Jul 16, 2017 10:28 am

TinkerPDX wrote:We are preparing to purchase a home from my in-laws, and they will owner-finance.

It occurred to me that the payments to them over the term of the mortgage could be identical for different combinations of purchase price and interest rate -- i.e., we could purchase it for X at Y%, or at some price<X, and rate>Y, and they would still receive the same monthly payment and the same total amount. Meanwhile, we'd have more mortgage interest to deduct (assuming that deduction remains / remains meaningful).

Is there some IRS rule preventing/limiting gaming the deduction this way? It seems like there must be, but I can't find it. In this case, the rate they would be willing to give us is probably lower than the rate we'd get on the market, so to the extent it's about transactions being arms-length/etc., there's at least a little wiggle room.

Appreciate anyone who can point me toward an answer.

(I'm going to engage an accountant and/or lawyer on this - there's also going to be a granny flat in the back that we'll lease back to them, so more tax planning potential - but I'm trying to figure out whether this first concept is just a non-starter before I get into getting professional advice.)


The IRS has rules about what interest rate (or range?) should be used when dealing with relatives.
I think this usually comes up when someone is considering lending a family member money at no interest, but it should be relevant otherwise, too.

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BolderBoy
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Re: gaming the mortgage interest deduction

Postby BolderBoy » Sun Jul 16, 2017 10:30 am

TinkerPDX wrote:(I'm going to engage an accountant and/or lawyer on this - there's also going to be a granny flat in the back that we'll lease back to them, so more tax planning potential - but I'm trying to figure out whether this first concept is just a non-starter before I get into getting professional advice.)

You might want to do a google search on "arm's-length transactions".
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jebmke
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Re: gaming the mortgage interest deduction

Postby jebmke » Sun Jul 16, 2017 10:34 am

One of the reasons seller-financing is carved out on Schedules A and B is to provide the IRS visibility to these transactions.
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bluebolt
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Re: gaming the mortgage interest deduction

Postby bluebolt » Sun Jul 16, 2017 10:36 am

Your parents would have to be OK paying income tax on the higher level of interest income from the higher interest rate.

Not Law
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Re: gaming the mortgage interest deduction

Postby Not Law » Sun Jul 16, 2017 10:36 am

Read up on "imputed interest" and the "safe harbor" rates.

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TinkerPDX
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Re: gaming the mortgage interest deduction

Postby TinkerPDX » Sun Jul 16, 2017 9:24 pm

bluebolt wrote:Your parents would have to be OK paying income tax on the higher level of interest income from the higher interest rate.


This one's an obvious answer I didn't realize I was looking for, as even if we could pass muster with a different rate than we'd otherwise use, our marginal tax rates won't be different (enough) to bother with this if it's just shifting income from one party to the other.

Thanks for the quick input everyone!

av8r316
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Re: gaming the mortgage interest deduction

Postby av8r316 » Sun Jul 16, 2017 11:43 pm

In addition to shifting income from a lower generation to a higher generation, you'd also have a lower basis in your house for purposes of deductions or gains.

SimonJester
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Re: gaming the mortgage interest deduction

Postby SimonJester » Mon Jul 17, 2017 9:03 am

The mortgage interest deduction is not all its made out to be.

For every dollar you send me I will give you back 25 cents to pay your taxes. Sound like a good deal?
"They who can give up essential liberty to obtain a little temporary safety, deserve neither liberty nor safety." - Benjamin Franklin

tampaite
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Re: gaming the mortgage interest deduction

Postby tampaite » Mon Jul 17, 2017 9:21 am

SimonJester wrote:The mortgage interest deduction is not all its made out to be.

For every dollar you send me I will give you back 25 cents to pay your taxes. Sound like a good deal?


What if "For every dollar you send me I will give you back 0 cents to pay your taxes. "

Something is better than nothing.

TIAX
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Re: gaming the mortgage interest deduction

Postby TIAX » Mon Jul 17, 2017 9:31 am

tampaite wrote:
SimonJester wrote:The mortgage interest deduction is not all its made out to be.

For every dollar you send me I will give you back 25 cents to pay your taxes. Sound like a good deal?


What if "For every dollar you send me I will give you back 0 cents to pay your taxes. "

Something is better than nothing.

Simon's point is if the plan is to raise the interest rate solely for the mortgage interest deduction, the OP will end up paying more.

tampaite
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Re: gaming the mortgage interest deduction

Postby tampaite » Mon Jul 17, 2017 9:37 am

TIAX wrote:
tampaite wrote:
SimonJester wrote:The mortgage interest deduction is not all its made out to be.

For every dollar you send me I will give you back 25 cents to pay your taxes. Sound like a good deal?


What if "For every dollar you send me I will give you back 0 cents to pay your taxes. "

Something is better than nothing.

Simon's point is if the plan is to raise the interest rate solely for the mortgage interest deduction, the OP will end up paying more.


ahh - thanks.

wangarific
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Re: gaming the mortgage interest deduction

Postby wangarific » Mon Jul 17, 2017 10:00 am

Wouldn't you be better off just gifting them money and having them give you the house in their will? (I'm not a lawyer so not sure about the legality of this type of handshake agreement)

You'd get the stepped up basis in the house, your gifts to them would be tax-free assuming you send them less than $56,000 a year (14k each from you to each of them), and you don't have the annoying paperwork.

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dodecahedron
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Re: gaming the mortgage interest deduction

Postby dodecahedron » Mon Jul 17, 2017 10:02 am

Here is a good article with points to think about:

http://www.investmentnews.com/article/2 ... r-strategy

My take on this: if your parents want to help you out, then they would probably be best off selling to you at FMV (fair market value) and giving you a low interest loan rather than discounting the purchase price.

Why?

1) The low interest loan does constitute a gift to the extent it is below the "Applicable Federal Rate" (currently 2.19% on loans with terms over 9 years) but unless the property is really expensive, it is unlikely that the annual interest "gift" will exceed the $28K annual combined exempt amount. Actually the annual gift exclusion could be $56K if they split the gift to you and your spouse and also between themselves) Even if the annual discounted interest does exceed $28K (or $56K), there are few married couples whose combined estates will exceed the combined gift/estate tax exempt figure of approximately $11 million. In any case, they can currently charge you 2.19% on a long term mortgage without any gift tax exposure at all, which is a good deal compared to bank finance.

2) The lower interest they charge you reduces their AGI and their effective marginal rate might be higher than you realize, once the impact on things like taxable SS and income related Medicare charges and senior citizen property tax breaks are considered. If they charge you more interest, you get an increased "below the line deduction" reducing your taxable income, but THEY get not only more taxable income but an increase in their ABOVE THE LINE Adjusted Gross Income.

3) The foregoing assumes that they can sell to you at FMV without generating enough capital gains to exceed the $500K exclusion on sale of owner occupied housing.

There is more discussion from Kitces here:

https://www.kitces.com/blog/an-efficien ... trategies/

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flamesabers
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Re: gaming the mortgage interest deduction

Postby flamesabers » Mon Jul 17, 2017 10:43 am

BolderBoy wrote:You might want to do a google search on "arm's-length transactions".


My thoughts exactly!

OP,

Anytime you engage in a (potentially) taxable transaction with a relative/friend that you wouldn't engage in with a unrelated party, it's bound to get scrutinized as an attempt to circumvent the tax code. If your in-laws sell you the home at below market price, this may be scrutinized as not being an "arms-length transaction." If you and/or your in-laws get audited, the IRS may treat the difference between the mortgage principal and the market value as a "gift" as homeowners don't normally sell houses below market value. Likewise, if your in-laws charge you an unusually high interest rate for the mortgage, the IRS may perceive this as you trying to make tax-deductible "gifts" to your in-laws. Unless you're an extremely high credit risk, people normally don't pay high interest rates on their mortgage.

Goal33
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Re: gaming the mortgage interest deduction

Postby Goal33 » Mon Jul 17, 2017 11:20 am

If you want to game your in-laws... you can make this deal, and then refinance
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jasc15
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Re: gaming the mortgage interest deduction

Postby jasc15 » Mon Jul 17, 2017 2:09 pm

How can the term and monthly payment remain constant with varying interest rate?

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#Cruncher
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Re: gaming the mortgage interest deduction

Postby #Cruncher » Mon Jul 17, 2017 2:30 pm

jasc15 in previous post wrote:How can the term and monthly payment remain constant with varying interest rate?
Here's an example. In all cases the 30 year term and $1,000 monthly payment remain the same. As the interest rate increases, the initial principal (i.e., the loan amount) decreases. Interest is the $360,000 total payments less the principal.

Code: Select all

Term                 30    
Payment           1,000    
Total payments  360,000    
Rate          Principal  Interest
----          ---------  --------
3.0%            237,189   122,811
3.5%            222,695   137,305
4.0%            209,461   150,539
4.5%            197,361   162,639
5.0%            186,282   173,718
Calculation of first two cases using the Excel PV function:

Code: Select all

237,189 = -PV(3%   / 12, 30 * 12, 1000, 0, 0)
222,695 = -PV(3.5% / 12, 30 * 12, 1000, 0, 0)

jasc15
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Re: gaming the mortgage interest deduction

Postby jasc15 » Mon Jul 17, 2017 2:36 pm

Oh, thanks, I misread. The other variable is the amount financed to keep total payments the same.


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