Selling house at a loss could have nasty tax implications

 

Kathleen PenderSunday, June 5, 2005Everyone knows residential real estate is a wonderful tax shelter. What's less well known are someof the tax disadvantages that can bite homeowners when they sell at a loss or wind up losing a housethat is worth less than they owe on it.With home prices soaring and foreclosure activity close to nil in the Bay Area, this is notsomething most homeowners are thinking about.In the nine-county Bay Area, there were only 39 residential foreclosure sales in April, down from 46in March, according to DataQuick.By comparison, in March and April 1995, there were 858 foreclosures in the Bay Area.I'm not saying whether the housing market will collapse, but people who are buying at today's loftyprices or who have leveraged their houses to the rafters may want to consider the tax consequencesif things take a turn for the worse.No tax deduction: If you sell your primary residence at a loss -- meaning for less than you paidplus the cost of improvements -- you get no tax deduction.This makes a certain amount of sense because the gain on the sale of a primary residence is tax freeup to certain limits. Assuming you lived in the house long enough, you can exclude up to $250,000 incapital gains if you are single and $500,000 if you are married filing jointly. Any profit overthose limits is taxed as a capital gain.No matter how much you lose on your primary residence, however, your tax deduction is always zero.This seems obvious, but it's not always.Sunnyvale CPA Leonard Williams says, "A prominent attorney referred a client to me. He paid $4.5million for a house that was now worth $4 million. He was going to go through this convoluted thingto sell it at a loss," thinking he could deduct it. "I said, 'This is a personal residence. Youcan't take a deduction.' "On the other hand, a loss on the sale of rental property is deductible. Williams says some peoplewho have a loss in their primary residence think they can move out, convert it to a rental and takea tax deduction."The problem is, if you bought it for $400,000 and it goes to $350,000, your cost basis in therental is not $400,000. It's going to be $350,000."If you sold it immediately for $350,000, you would realize no gain or loss.The value of the rental "would have to continue to go down to get the benefit of a loss," saysspokesman Jesse Weller of the Internal Revenue Service. "You wouldn't be able to claim the portionof the loss that occurred while it was your home."Foreclosure taxes: Suppose your house becomes worth less than you owe, you can't keep up themortgage payments and the lender forecloses on the property.You may be liable for two types of taxes: capital gains and cancellation of debt income. The sameholds true if you abandon the property or voluntarily turn it over to the lender.These taxes depend on whether you have a recourse or non-recourse loan.Non-recourse generally means that if the lender takes over your house, your debt is satisfied andthe lender can't go after your other assets, even if the proceeds from the foreclosure sale are lessthan the debt.In California, if you take out a loan to buy a house or a building with up to four units and youlive in the house or one of the units, the loan is non-recourse.A recourse loan generally means the borrower is personally liable for repayment. If the lender takesover the house that is worth less than the debt, the lender can go after the borrower's other assetsto pay the difference.A home equity loan or line of credit is a recourse loan. So are consumer loans secured by yourhouse.In most instances, if you refinance your house, the new loan is a recourse loan, says MichaelPfeifer, a real estate attorney with Pfeifer & Reynolds.However, Roger Bernhardt, a professor at Golden Gate University School of Law, says there is noCalifornia case law that definitively establishes this as fact.If you borrow money to buy investment property, it is generally a recourse loan unless it wasfinanced by the seller, in which case it is typically a non-recourse loan.-- Non-recourse loans. If you default on a non-recourse loan, you could be subject to tax on capitalgains, but you won't be taxed on the cancellation of debt.When a lender takes over a property, it's treated as a sale. Your "sales" price is the outstandingdebt.Your capital gain or loss is the difference between this debt and your adjusted basis, which isusually the amount you paid plus capital improvements (minus depreciation, if it's a rentalproperty).If the debt exceeds your basis, you will have a capital gain even if you don't get a dime in yourpocket. If this is your primary residence, and the gain is less than $250,000 (single) or $500,000(married), you won't owe tax.If the debt is less than your cost basis, you will have a capital loss.Suppose you buy a house for $600,000 and make no improvements. You put down $60,000 and borrowed$540,000 with an adjustable-rate, interest-only mortgage. Interest rates shoot up, home values falland a year later you can no longer make your payments. The bank takes over your house, now worthonly $500,000.You will have a capital loss of $60,000 ($540,000 in debt minus your cost basis of $600,000.) Youwon't owe tax, but you won't get a deduction if this is your primary residence. The biggest hit willbe to your credit rating.-- Recourse loans. With a recourse loan, your "sales" price is the fair market value of the house atthe time of transfer. Your capital gain or loss is that value minus your cost basis.In the above example, if the mortgage was a recourse loan, you would have a $100,000 capital loss($500,000 in fair market value minus $600,000 cost basis).With a recourse loan, you also may owe tax on cancellation of debt income. If the home is worth lessthan the debt and the lender does not go after you for the difference, that difference becomescancellation of debt income, and it will be taxed unless certain exceptions apply.In the above example, you would have $40,000 of taxable debt forgiveness income ($540,000 in debtminus $500,000 in fair market value), assuming you don't qualify for any of the exceptions.Cancellation of debt is not taxed if the loan forgiveness was intended as a gift (not likely unlessthe lender was a close relative), if the borrower is bankrupt or insolvent and in certain othercases.Cancellation of debt tax is rare, but it usually comes as a nasty surprise to those who owe it."A lot of people don't understand the tax consequences of walking away from their property," saysWeller.Cancellation of debt is taxed as ordinary income. If it exceeds $600, most lenders are supposed tosend you IRS Form 1099-C showing the amount you must report on your tax return.Here's one more example:Pretend you bought a house for $100,000. Its value goes up to $280,000. You refinance your originalmortgage with a new one for $250,000. The value goes down to $200,000, you default and the bankforecloses.This will probably be treated as a recourse loan because it was not acquired to buy the house.Assuming you still owe $250,000, you will have $50,000 in cancellation of debt income and a capitalgain of $100,000 ($250,000 market value minus $100, 000 cost basis.) Once again, the capital gainwon't be taxed because it falls within the exclusion for primary residences.Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at kpender@sfchronicle.com.Page E - 1http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2005/06/05/bugg5d3fns1.dtl