After years of soaring home prices, housing values are falling in many areas of the U.S. In some cases, homeowners are selling for less than their mortgage balance or even walking away from highly leveraged houses. Such actions can have serious and unexpected tax consequences. However, temporary relief is available, thanks to the Mortgage Forgiveness Debt Relief Act of 2007, which President Bush signed into law at year's end.
The tax code generally requires a taxpayer to pick up taxable income when debt is discharged. That is, if a lender forgives debt you owe, you will have income equal to the amount of the cancelled debt.
Example #1: Suppose Jim Smith bought a house for $450,000 at the peak of the real estate boom. He made a $50,000 down payment and obtained a $400,000 mortgage. Jim, who used the house as his primary residence, was personally liable for the mortgage. In 2007, when the loan balance was $390,000, Jim got a job in a different city and sold the house. He received only $350,000 because the house had lost value. As you can see, Jim lost his $50,000 down payment. What's more, the $350,000 he received was not sufficient to cover the $390,000 mortgage value. Nevertheless, the lender agreed to accept his $350,000 and canceled the loan, effectively forgiving $40,000. Normally, the lender would report that $40,000 cancellation of debt to the IRS. Likewise, the lender would report to the IRS when a mortgaged property was abandoned, foreclosed, repossessed, or reacquired by the lender. In all such case, the resulting income would be taxed at ordinary income rates. With $40,000 in taxable income from cancellation of debt, Jim might owe $10,000-$15,000 in tax.
The new law relieves Jim from having to pay this tax. This provision is retroactive, so it applies to discharges of home mortgage debt that occurred in 2007. A similar tax shelter applies to debt cancelled in 2008 and 2009. Up to $2 million of cancelled debt qualifies for the tax relief. As you might expect, there are limits to the tax break. For one, it applies only debt relief from "qualified principle residence indebtedness." That is, the exception to prevailing law applies only to debt that was used to acquire, construct, or improve your principle residence, and the debt must be secured by that residence. Thus, there is no tax break for discharge of home equity loan if the loan proceeds were used for purposes other than home improvements. Debt relief for vacation homes and investment property also will trigger taxable income. What's more, if you do use this provision to avoid cancellation-of-debt income on your principal residence, the basis of your home (its cost for tax purposes) will be reduced by the amount of canceled debt. This might cost you tax on a sale if your long-term gain is over $250,000 ($50,000 for couple filing joint returns).
In the preceding example, this new law will save Jim some tax, but he still faces a difficult situation. On a personal residence sale, you can't deduct the loss and you can't use the loss to offset the tax you owe on a capital gain from another asset sale.
Example #2: What if Jim decides to rent the home to a tenant instead of selling it at a steep loss? He might plan to use the home as a rental property until the housing market recovers. In the meantime, he'll live elsewhere and collect rental income. Here Jim faces another unpleasant surprise. According to the tax code, when a tenant moves in and a former residence is converted to rental property, the home gets a new basis. That basis will be whichever is lower, the owner's current basis or the fair market value of the house. Here, Jim's basis in the converted property would be its depressed value of $350,000. If he sells a year later for $375,000, he'd have a $25,000 taxable gain on a property he bought for $450,000 and sold for $375,000. In fact, the IRS might say that Jim's basis (the value of the house at the time of its conversation to rental property) was lower than $350,000. Then he'd owe even more tax on the sale. To avoid this problem, Jim should obtain a timely appraisal when the conversion takes place. He could ask a local real estate agent for a dated statement, assigning a likely selling price for the house at that time.
Example #3: What if Jim had bought a house as investment property in 2004 or 2005? Suppose he wants to sell because the house is losing money- even if that means taking a loss on the deal. In this scenario, Jim loss would be a capital loss, for tax purposes. He could use that capital loss to offset capital gains, though; he can deduct only $3,000 per year against his ordinary income. He can carry forward unused losses to later years, but they will continue to be of limited value (a $3,000 deduction each year) until and unless he has capital gains to offset. The bottom line is that there are many pitfalls that you must avoid if you own real estate that has lost value. Our office can help you by examining your options and explaining their outcomes so you can make a fully informed decision.
Falling prices have created a buyer's market in housing. The same trends might encourage you to shop for a home that you can rent to tenants. Rents may firm as more would-be-home buyers are denied mortgages and rent homes instead. What's more, tax breaks for real estate investors can make such ventures attractive.
Owners of investment property are entitled to some non-cash deductions, such as depreciation. These deductions may help you avoid tax on any net rental income you receive.
Example: Suppose that you buy a house that you rent for $2,000 per month. That's $24,000 per year. Also suppose that all of your expenses add up to $19,000 per year. You would put $5,000 into your pocket. However, you might have a $9,000 depreciation deduction in this hypothetical example. Now you'd have a $4,000 loss, for tax purposes. With a taxable loss, you'd owe no tax. Thus, your $5,000 in cash flow will be tax free, sort of.
Is this tax-free cash flow really tax-free? Not exactly. Depreciation deductions lower your basis in the property. A lower basis, in turn, will increase your tax on an eventual sale. Fortunately, the tax on prior depreciation deductions is capped at 25%. Thus, you may defer tax normally owed at rates up to 35% and pay it years later at a 25% rate. There is actually a way to avoid paying tax on the depreciation deductions you've taken. Under current law, assets such as real estate get a basis step-up to market value when they're left to heirs. Therefore, if you hold on to investment property until death, your heirs can sell the property for its current value and owe no capital gains tax. All the tax-free cash flow you receive during your lifetime will never be taxed.
In the example above, you wound up with a $4,000 loss, for tax purposes. Such a loss might be deductible, depending on your adjusted gross income (AGI). Losses from rental properties are known as passive losses. If your AGI is no more than $100,000, passive losses are deductible, up to $25,000 per year. Over $100,000, this deduction is phased out. Say you own a rental property with a tax loss and your AGI is $120,000. You are 40% of the way through the $100,000-$150,000 phase-out range, so your maximum passive loss deduction is 60% of $25,000: $15,000. If your AGI is $150,000 or more, you generally cannot deduct passive losses.
If you have passive losses that you can't deduct right away, they may be carried forward to future years indefinitely. Those losses can be used to offset any taxable income you might have from rental properties. If you haven't used your passive losses by the time you sell the property, they will be deductible against your ordinary income in the year of the sale. If you have a gain on the sale, favorable capital gains rates will apply.
The tax laws described above relate to passive losses. Your losses won't be passive if you are a real estate professional. To be treated as a real estate professional, you must spend more than half your working time on real estate- at least 750 hours a year. Then you can deduct any losses from rental property right away, regardless of your AGI.
| Limits on Passive Activity Loss Deductions | |
| Adjusted Gross Income | Maximum Annual Deductions |
| Up to $100,000 | $25,000 |
| $110,000 | $20,000 |
| $120,000 | $15,000 |
| $130,000 | $10,000 |
| $140,000 | $5,000 |
| $150,000 or more | $0 |
| Source: www.webtax.com | |