Dear Tax Talk,
My wife and I purchased a home in February 2001, and lived in it for one and a half years before we left to further my education out of the state. We kept the house as a rental for all these years.

In 2007, we refinanced the house and took money out to start paying down student loans (we thought we were being responsible). We have kept it as a rental until recently, when we placed it up for sale.

However, recently I have wondered if I will be required to pay capital gain tax when I sell the home for the money I took out during that refinance. Do you pay it when you take the money out or only when you sell the house? The amount is about $70,000.

I think I will pretty much break even on the mortgage/sales price when I sell it now. But I am worried if I will have a tax burden to face upon the sale. I do plan on buying another house soon if that makes any difference.
— Brad

Dear Brad,
Until the mortgage blowup and real estate crash, borrowing against existing properties was a way of making a living. Now with declining values and tightened credit, those days are pretty much gone.

One of the reasons borrowing was so attractive is that it allowed you to keep your existing appreciating properties and it was tax-free. If you sold to acquire more properties, you would have lost future appreciation and incurred a tax consequence.

Borrowing allowed you to defer the tax consequences until you sold. However, when you did sell, the proceeds would go to pay off the debt, leaving you with little cash to cover the tax consequences. You’ll probably be in a similar position when you sell the rental property.

The additional borrowing does not change your cost basis in the rental property. Hence, your basis for determining gain on the sale is your original purchase price.

For example, assume you paid $200,000 for the home and obtained a mortgage for $180,000. The home’s value shot up and you were able to borrow the additional $70,000 to pay off your student debts. You now have $250,000 in debt, which is what the house is now worth. When you sell, you’ll have $50,000 in gain and no cash. At the 15 percent maximum capital gains rates, your tax will be $7,500, which you’ll have to get from other sources.

On the bright side, you’ve only paid $7,500 in tax to eliminate $70,000 in debt. If you and your wife had worked to get rid of the $70,000 in debt, you probably would have had to make more than $100,000 to be left with enough cash after income and payroll taxes to pay that debt off.

If you’re thinking of buying another property to replace the rental unit, you can always look at doing a like-kind exchange. Unfortunately, with little or no equity in the current property, you’re going to have to come up with a down payment to make it happen.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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