Capital gains are realized when any capital asset, which includes most classes of personal property, are sold for a profit. While there is generally no restriction on how you may use such monies, there are circumstances in which there could be limitations.
In the U.S., capital gains -- both short- and long-term -- are most significant from the perspective of taxation. The tax rates on short-term capital gains, which are gains on property held for a year or less, are generally the same as for ordinary income. Long-term capital gains, however, are taxed at a much lower rate. These tax rules apply to all capital gains, including those realized from the sale of real estate, with a single important exception -- when you sell your primary residence at a profit, no tax at all is due on the first $250,000 ($500,000 if married) of capital gain. It’s usually not even necessary to report the sale.
Before 1997, the only way most people could avoid tax on capital gains realized from selling their primary residence was to purchase another house within two years for more than they sold the old one. One other option was available to those over 55: they could exempt, on a once-in-a-lifetime basis, up to $125,000 in capital gains.
Restrictions on the Use of Capital Gains
If the property on which the capital gains are realized is held by a trust or a retirement account, the terms of the trust may limit how gains are used. Likewise, if the capital gain is realized on property held by a retirement account, then it could be used to retire a second mortgage only on property also held by the retirement account. For instance, if you own an IRA that has invested in rental properties and sell one of the properties for a profit, you can use that profit to pay off a second mortgage on another properly held by the same IRA. You could not use it to pay the second mortgage on a property not held by the IRA, though. Technically speaking, retirement accounts do not generate capital gains regardless of the source of funds. All withdrawals made from tax-deferred retirement accounts are taxed as ordinary income.
Using Capital Gains from Real Estate to Retire a Second Mortgage
With the exception of the noted potential restrictions, capital gains realized from selling real estate can be used for any purpose, including to pay off a second mortgage. If the reason is to retire a costly debt and free up some money every month, though, you should consider the effective interest rate. If your effective tax rate is 25 percent, and your second mortgage is 7 percent and is tax-deductible, your effective interest rate is only 5.25 percent. For this reason, and also because some second mortgages carry prepayment penalties, it’s prudent to review such a decision with a good accountant before writing a check.
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