The housing market collapse affects more than the stock market. A host of tax issues are raised for homeowners, and different techniques are called for to sell a house in a buyer’s market.
Many homeowners leveraged their purchases with the maximum debt possible to get the largest McMansion possible. Often, as home values increased, home equity lines were used to extract cash. When the homeowner cannot meet mortgage payments, the house may be foreclosed by the lender. Unfortunately, many of the common scenarios in this type of market have lousy tax results. Use the following checklist to make sure you’re getting your share of tax pain:
When a homeowner sells a home at a loss, there is unlikely to be any tax deduction permitted for the loss. Treas. Reg. Sec. 1.165-9(a). A deduction is permitted for business property (e.g., a portion of the home is rented or used in a trade or business and depreciated). IRC Sec. 162(a). A deduction may also be permitted for a loss suffered as a result of a casualty affecting the residence. IRC Sec. 165.
Trying an end run around the above rule won’t work. A homeowner might think that if their home has declined in value, if they rent it out for a sufficient period of time to demonstrate that the property has transmuted into a rental property, then they can sell it at a loss and qualify to deduct that loss. No dice. First, the conversion process is not simple. The IRS and the courts are well aware of the potential for abuse. The conversion will require real independent steps to corroborate the conversion, demonstrating that the personal use of the property has been permanently abandoned, that a lease or other evidence of the business use exists, the quantum of business activity, reporting for tax purposes as a business property, not residence, etc. Merely attempting to rent the home may not suffice. Grohse, TC Memo 1968-47. But the real clincher is that any decline in value occurring prior to the conversion will not be able to be deducted. Only declines in value after the conversion will be permitted. The mechanism by which the tax laws affect this is to provide that the homeowner’s tax basis (the amount on which gain or loss is calculated) is the lesser of the cost basis or fair value on the date of conversion. Treas. Reg. Sec. 1.165-9(B)(2). Tip: Obtain a written appraisal of the value of the house on conversion.
Some homeowners may legitimately want to convert their home to a rental if they cannot sell it. Unlike the homeowner above who was seeking to take a tax deduction for the loss on sale, this homeowner may hope to use the tax losses from the rental to offset other income. Good try, but the passive loss limitation rules may prevent this benefit from being realized. (Passive losses are tax losses from rental real estate properties, for example, as a result of depreciation write-offs, or from investments as a limited partner.)
Renting your home in a down market may also undermine the ability to take advantage of the home sale exclusion. This rule permits a homeowner to exclude the first $250,000 of gain, (or $500,000 for a married couple). To qualify, the home had to have be used as a principal residence for two of the five years before the sale occurred. Too long a rental will disqualify the home. Example: If you bought your home for $800,000, it appreciated to $1.8 million, then dropped to $1.2 million, you may have a psychological loss of $600,000, but you still have a tax gain of $800,000.
In tight real estate markets some homeowners will rent, rather than sell and lock in their loss. However, to entice a tenant to consider buying at a later date, an option is sometimes included in the transaction. When an option to purchase is given to the tenant in the lease agreement, the IRS may assert that the lease with an option to purchase should be re-characterized as a sale of the property on the installment method. If the homeowner is given a credit for a portion of each rental payment, as the percentage of that credit to the rent paid increases, the risk of re-characterization will also increase.
Generally, if a lender forgives a borrower’s debt, the borrower will realize income on the cancellation of the debt. If the borrower was insolvent or bankrupt, gain can be avoided. If the home is foreclosed, the excess of the debt over the fair value of the home (which is presumed to be the foreclosure sales price) is characterized as income from the discharge of debt.
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