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March, 2004 Tax Tip

Selling and Replacing Your Residence

Clients have asked me whether it is always wise to sell their current residence before buying another.  As is often the tax answer, it depends on the circumstances.


Assume, as is normally the case, you own a home with a mortgage and wish to sell it and buy a new home with a mortgage.


If you are fortunate enough to have sufficient income to carry both mortgages and also sufficient cash reserve to purchase the new home without having to transfer equity from the sale of the old, you are in the best of all worlds.  You can buy your new home first and sell the old one at your leisure, after you close on the new one.   In a rising real estate market this will permit you to be in the most favorable situation at both ends of the transaction.  The interest on both loans would, in nearly all cases, be deductible.


Now let’s assume you have enough income to carry both mortgages, but not enough cash to close on the new home without getting some equity out of your existing home.  Probably the easiest way to get it is to take out a home equity line of credit on the old house.  This will give you the same flexibility you had in the first situation above.  You can now buy your new home and, upon sale of the old home, you pay off the two loans.


Finally, assume you don't have enough income to carry two mortgages, so you can’t buy the new house until you sell the old one and pay off the existing mortgage.  It is not always possible to close transactions on the same day.  If you sell before you buy, you will likely incur additional expenses for a place to stay for the intervening period as well as a place to store your belongings.  For this reason it is recommended that you have your existing home sold before buying the next one, but set the closing date on the sale to occur after the closing date on the purchase.  That will allow you to remain in your existing home until you move into the new one. The new lender will disregard the old mortgage in qualifying you because you have a contract to sell the old house, which will pay it off.  If you should need some of the equity in your current home to complete the new deal, you can obtain a short-term (often referred to as a “bridge” loan)" from a bank that is repayable when you sell the old home.  In this situation it is quite likely that both the bank and the new mortgage lender will ask to see a valid contract of sale, including a significant deposit and absence of conditions that will allow the purchaser to walk away from the sale.


Another question I have been asked is whether one can qualify for a loan if he or she has no income from earnings, but has substantial investment income.   One would surmise that investment income should be on a par with income from working.  However, the potential problem lies in the fact that investment income is more difficult to verify.  I can tell you that several of my clients, particularly elderly ones, have obtained loans solely on investment income.  Lenders who make loans on investment income will rely heavily on income tax returns for recent years, just as they do in qualifying self-employed individuals.  The assumption is that any errors will be in favor of understating, rather than overstating, income.  To verify that you have provided them with your true returns, they will ask you to authorize them to obtain copies directly from the IRS.   In some cases they may obtain copies directly from the preparer.


Ordinarily, the only investment income that is acceptable in qualifying for a mortgage is interest, dividends and retirement income.  Borrowers who believe they have more income than lenders will credit them for may ask to qualify using   "stated income”.   In this case the lender will accept the income the borrower states, but there is a cost which is usually either a higher loan rate or some fraction of a point of the loan amount.



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