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Real estate exchange may not defer taxes

DEAR BOB: I am doing a tax-deferred exchange of two properties I own in South Dakota. One property has a $40,000 mortgage. The other is free and clear. The replacement property is in Florida. I recall reading in your articles that to defer my profit tax I must trade equal or up in both value and mortgage debt. If I do not have a mortgage on the Florida replacement property, will I be creating a taxable situation? – Larry J.

DEAR LARRY: First, all the properties in your Internal Revenue Code 1031 tax-deferred exchange must be held for investment or for use in a trade or business. I hope none of these properties is or will be your personal residence (which is not eligible for a tax-deferred exchange).

Second, if you owe $40,000 less after the exchange of two qualifying properties for one large property, that means you received $40,000 taxable "boot" (defined as "unlike kind" property, such as cash).

If you can pay off that $40,000 mortgage on your South Dakota property before the exchange, that should solve your tax problem. If you can't do that, however, paying capital gain tax on $40,000 shouldn't be too difficult.

Third, please review the exact details of your planned transaction with your personal tax adviser before you sell the first property. Then you can be sure you comply with the IRC 1031(a)(3) Starker exchange rules to have a tax-free property trade.

IS AN "INTEREST-ONLY" HOME MORTGAGE TAX DEDUCTIBLE?

DEAR BOB: I recently read in your article about those new "interest-only" home mortgages. Last September we bought two lots, which contain one house. We plan to totally remodel the house. Our financing is an interest-only mortgage. Are the mortgage interest payments tax deductible? – Patti L.

DEAR PATTI: Yes. The interest you pay on an interest-only mortgage is tax deductible. It is a personal itemized interest deduction on your income tax return if the home will be your personal residence after remodeling.

However, if you acquired the property as a rental investment, then Schedule E is the appropriate place to deduct the mortgage interest and other applicable expenses. This is the same place you report rental income. For full details, please consult your tax adviser.

RULES FOR A PRESCRIPTIVE EASEMENT

DEAR BOB: Forty-two years ago, my parents had a house built by a developer. Their driveway to the road is over a culvert, which drains the adjoining lots and the street. The vacant lot next door was recently purchased by a home builder who informed my mother he plans to build a house on his lot. The builder informed her to remove her car, which had been parked on "his lot" by approximately 3 feet. My parents presumed the driveway and culvert are on their lot. The new owner's survey shows the lot line is 1 foot on the existing driveway. What recourse does my mother have? She is 82, a widow, and doesn't need any stress. I suggest she ignore the situation. What would you do? – Robin D.

DEAR ROBIN: If necessary, your mother may need to hire a local real estate attorney to perfect her prescriptive easement to continue using part of the adjoining lot.

The legal requirements for a prescriptive easement are open, notorious (obvious), hostile (without permission), and continuous use for the required number of years in the state where the property is located. It appears your mother meets those legal tests.

If the new neighbor causes any further trouble, a pre-emptive letter from her local real estate attorney might prevent future legal difficulty.

You and she should know surveys are not always accurate. Your mother might want to have her lot surveyed by a different surveyor to see if the neighbor's survey is correct.