Q. We are in pretty good financial shape and are considering the purchase of a small house from an elderly friend for $250,000. She plans to move in with her daughter and could use money to help with some home health care and other expenses so as not to be too much a burden, and we think it would be a good investment. The house would be a teardown, and the lot can be divided to allow two homesites. We plan to hold the land until the economy turns around, then build one home, sell it and on to the next. In the meantime, we are wondering about the best way to pay for the property. We think the economy will improve within the next two years, so we are considering a two-year ARM at 3.75 percent to finance the purchase. We hate paying interest, but we'd get a tax deduction, and it seems like a better plan than cashing out our CDs since some of them are paying over 5 percent. We could also refinance our current home and take out enough equity to pay cash for the property, which would also give us a nice tax deduction. Our CDs mature at various times, and they will all mature in two years, so we'd pay down either the ARM on the property or the refinance debt as they mature and we'd be able to pay it all off in two years. Is it better to refinance, take the ARM on the property or another option? Are we able to deduct property taxes on the land? It sounds like you are in excellent financial shape. I'll provide some information, but you should meet with a tax professional before you take any action.
If the loan you take out on the property is considered as a mortgage for a second home, the interest would be tax deductible. Interest on a third home is nondeductible personal interest unless the home is business or investment property. If the purchase is considered investment property and not a primary or secondary residence, you can only deduct the interest to the extent you realize income (the rules for real estate professionals are different). You can carry the deduction forward and take it in future years when you have income from the property. Property taxes can be deducted as an itemized deduction on Schedule A.
If you refinance, your interest deduction may be limited. To be deductible, the interest must be either acquisition or home equity debt. Acquisition debt is debt incurred to acquire, construct or substantially improve your primary or second home. When you refinance, any debt exceeding the principal outstanding on the loan immediately before the refinancing is not acquisition debt. Home equity debt is limited to the lesser of the fair market value of the home minus total acquisition indebtedness on the home or $100,000. A single loan can be treated as part acquisition debt and part home equity debt when claiming interest deductions. Example: If you don't currently have a mortgage and refinance taking a $250,000 mortgage, the interest deduction will be limited to interest paid on $100,000 because your previous acquisition debt balance was zero.
