Several weeks ago, a reader asked, hypothetically of course, what would happen if she should win a house in a contest she entered.
The house to be won was worth approximately $230,000. She and her husband currently own a townhouse worth $150,000, but they’re carrying a $110,000 mortgage.
Should they be lucky enough to win the house, I suggested that the IRS would treat it as if they had just won $230,000 in cash. This, in addition to their current incomes, would almost certainly bump them up to the top tax bracket, where they’d pay approximately 39 percent of their income plus state taxes.
Assuming their annual income is $50,000 per year, the government would assume that they had earned $280,000 that year. They’d owe approximately 39 percent of that income, plus state taxes, or around $100,000 (if they have some deductions, that could lower their adjusted gross income).
Unless they have a wad of cash sitting around – I estimated they’d need about $75,000 if they opted to sell their home and move into the new home — I suggested they’d be much better off financially if they sold the house, paid the taxes, and invested the rest.
But a bunch of readers wrote in to say that I missed the most obvious solution: Get a new mortgage to pay off the taxes. It’s an excellent suggestion, and I sure missed it. Here are several variations on this theme, courtesy of the readers of this column:
Nancy wrote: “Often, the tax consequences are forgotten when we contemplate ‘instant’ riches. However, there is another alternative for paying the taxes should these people win the house.
“They could just keep the house and place a mortgage on it to cover the tax cost. If they took a $90,000 loan against the property, they would have a smaller mortgage than the $110,000 mortgage they currently have and the interest would be deductible.
“They could sell the townhouse and use the $25,000 proceeds for investment. If they meet the two-year occupancy requirement, the proceeds (from this sale) would be tax free. They’d be left with substantial equity in the new, and presumably larger and better home and a lower monthly payment…..a win-win for them!”
That’s an excellent and financially savvy solution. Thanks for writing.
Robert wrote: “I’m afraid your answer is totally off-base. You told her to sell the home if she won it since she’d have a large tax bill ($89,700 plus state tax) and she didn’t have cash available to pay it.
“The solution is simple. She and her husband should take out an 80 percent mortgage and get $184,000 in cash tax free for the home. They then pay off the tax of around $100,000, let’s say $90,000 to the IRS and $10,000 to the state) and have $84,000 in cash to invest.
“They can either sell her current townhouse and get another $25,000 or so in cash or keep it and rent it out. Then they have a nice house to live in, maybe rental income and more tax writeoffs, one or two houses appreciating in value, and plenty of cash to invest (if they do the prudent thing) in a mutual fund.
I see this as a better alternative than your answer.”
The only problem with your solution, Robert is that this couple probably only has income of $50,000 per year. I don’t know a mortgage company that would lend nearly $300,000 ($184,000 plus their current $110,000 mortgage) in loans to a family earning $50,000 per year.
Then, there’s the question of getting enough rental income to make the whole thing work. In his email, John suggested that if the couple took out just enough of a mortgage to pay the taxes on their new home, and then converted their existing townhouse to a rental unit, it might not stretch their budget too far.
The original letter writer didn’t include any specifics about where she lives or how much rent she could get for her townhouse. So let’s go out on a limb and look at how much she’d need to get in rent to make the rental option work.
With a $110,000 30-year fixed rate mortgage at 8 percent, her monthly payments are 806.74. Her taxes (2 percent of $150,000 is a safe bet), are probably about $3,000 per year, or another $250 per month. She lives in a townhouse development, which surely has a monthly association fee. Let’s assume it’s $100 per month. Her total monthly cost for these items is $1,156.74.
Not including depreciation, because we don’t want her to lose money on a cash in-cash-out basis each month, she’d probably have to get a tenant willing to put up at least $1,200 per month to make the numbers work.
If that’s the case, she could certainly qualify for a large enough mortgage on the new home she and her husband might win to both pay her taxes and use her existing home as an appreciating investment property.
My thanks to the dozens of readers who wrote in. Now that we have the financials all worked out for them, I hope our “dreamers” actually land their piece of the American Dream.
June 19, 2000.