Once you've collected the capital gains from the sale of your real estate, you can use them for whatever purpose you wish. The Internal Revenue Service doesn't limit how you spend them. If paying off a second mortgage meets your financial goals, you can apply the capital gains you've collected to do it. However, to get those capital gains, you'll have to sell the property. If you don't want to sell, you may need to find other ways to pay off the mortgage.
Gain vs. Profit
A capital gain is different from the paper profit that you earn when your property's paper value goes up. Capital gains refers to the profit that you earn when you sell your property. The only way you can access a capital gain to pay off a second mortgage is to sell the property on which you have the gain. As such, this strategy really only works if you want to take the gain to pay off a second mortgage on a different property. On the other hand, if your property's value has increased, you may be able to pull money out of it to replace or refinance a second mortgage against it without selling it.
Selling Your Property
If you choose to sell your property to free up money to pay off a second mortgage, you might be able to get that money tax-free. If the property is your primary residence and you've lived in it for two of the past five years, the IRS allows you to exclude up to $250,000 in gains if you're single or $500,000 in gains if you're married. If you don't qualify for the exclusion because you haven't lived there long enough, the house is your second home or it is a rental property, you will have to pay capital gains tax on any profits that you pull out.
To Pay or Not to Pay Off?
While paying off your second mortgage can free up income every month, it's not always the best option. If your second mortgage's interest is tax-deductible, your effective rate is lower than what it may seem. For instance, if your second mortgage carries a 6 percent interest rate, but you pay taxes at a 25 percent rate, your after-tax interest rate is only 4.5 percent. As such, you might do better to keep the loan in place and invest the money you'd use to pay it off elsewhere for a higher rate of return.
Retain and Refinance
Instead of cashing out your capital gains, if your house's value has gone up, you have another option. You may be able to use your increased value and equity to refinance your first mortgage and fold your second mortgage into it. Because first mortgages usually have lower rates than second mortgages or equity loans, you'll end up saving money if you can get a good rate on the first mortgage.
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