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Home  > Money >  Money Priorities

Clear Debt Permanently
by Peg Downey

This week Peg tackles a tough situation with no easy answers. Bottom line is that unless you have a sound financial plan in place, clearing your debts will just open the door to more red ink.

The Financial Picture
Debt: $40,000
Combined Income: $85,000
Mortgage: $14,400 a year
Value of second property: $60,000
Owed on second property: $28,000

Question: My wife and I have accrued about $40,000 in debt, and money is getting tight. We make a combined income of about $85,000 a year. We have a $1200 monthly mortgage payment, no car payments, and the accrued debt is mostly credit cards and loans.

My son attends a private school, but that is paid from our tax refund. We have a rental property valued at about $60,000, and we owe $28,000 on the property. I am thinking of selling that property to clear our debts and then cut up our credit cards and clear up our credit rating.

Will I have to pay capital gains tax on the property sale? I've heard of a one-time tax exemption, but I understand this money must be put into a retirement fund or used toward the purchase of a new home. Can you help?

Answer: You're in a hard spot. I'm going to start by asking a few tough questions: What did you buy with your credit cards and loans and how will you pay for similar items in the future?

The answers are key to finding a solution. Experience tells me that unless folks have a livable spending plan, they will just run up their debt all over again. Start by identifying everything you spend money on, then see how you can bring these expenses in line with your income. This must happen before you can take any other action such as paying off debt.

Your tax refund is merely forced savings that pays no interest. If tuition remains a priority and you can be sure you are overpaying your taxes enough to pay it, then this is one way to save. The approach is the same for anything that you pay irregularly set aside half the necessary amount each month (that's what happens when you have extra withheld from your paycheck) and in a year you'll have the money you need.

Develop a spending plan that lets you live within your means and still save for expenses such as insurance bills or tuition. Follow the plan for at least three months to see if you can do it. Only then can you begin to consider paying off your debt.

Have you been getting income from your rental property and using that for anything other than paying down debt? If so, how will you replace that income?

And you will probably owe taxes on the sale, because the exemption you mentioned applies only to private residences, not to rental property. So, how much will you clear after repairs, commissions and taxes? You need a good accountant or financial planner to help you, but I do know that the proceeds won't be enough to eliminate your debt. And do you know what return you've been getting on this property? Perhaps it is too good an investment to sell.

Your plan to cut up your credit cards and clean up your credit rating is an absolute must. Then, you can evaluate the investment value of your rental.

Related Stories
• Who Is Peg Downey?
• Of Higher Interest Archive
• Broader Market Archive
• Money Wise Archive

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Related Stories
• Who Is Peg Downey?
• Of Higher Interest Archive
• Broader Market Archive
• Money Wise Archive

Related Books
• The Seven Stages of Money Maturity, George Kinder
• The Courage to Be Rich, Suze Orman
• When Are You Entitled to New Underwear, Eileen Michaels

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