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Circular 230 Disclosure, United States Treasury regulations effective June 21, 2005 require us to notify you that to the extent of this communication, or any of its attachments, contains or constitutes advice regarding any U.S. Federal tax issue, such advice is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that can be imposed by the Internal Revenue Service.
Life After the Real Estate Bubble Burst
With lenders becoming more conservative, money tightening up, and the real estate market in decline, many homeowners and speculators find themselves faced with some unpleasant choices. One strategy is to wait until home prices rebound, but that could be some time and probably too far off for the owner with a variable rate or short-term introductory rate loan and increasing mortgage payments.
There are other reasons—such as job relocation, divorce, declining income or poor health—that can force a property owner to sell in a down market and possibly take a financial loss. This article explores the tax ramifications of selling a home or rental property at a loss. But first, here are some terminology and tax rules associated with selling property:
• Personal-Use Property
- The general rule that applies to personal-use property is that gains are taxable as capital gains but losses are not deductible. Examples of personal-use property are the family car (no business use) and the family home or second home. So, if you sell your personal residence or second residence at a loss, that loss is not deductible.
• Investment Property
– For investment property, generally, gains are taxable and losses are deductible as capital gains/losses. However, the amount of capital loss that can be deducted annually is limited. If, after combining all investment capital gains and losses, the result is a loss, the loss is generally limited to $3,000 per year. Examples of investment property include vacant land or improved real estate that is not a business property, home or second home.
• Business Property
– The general rule for business property is that gains are taxable as capital gains and losses are deductible as ordinary income. Examples of business property include residential rentals, commercial rentals and an office-in-the-home.
• Primary Home Sale Gain Exclusion
– Generally, an individual who owns and lives in a home for two of the prior five years can exclude $250,000 of home sale gain. This applies to each individual so a couple could exclude $500,000. In addition, an individual who does not meet the two-out-of-five requirements may still be able to exclude a lesser amount if the home was sold due to certain unforeseen circumstances.
Now let’s apply these general rules to some representative situations that are likely to occur in a down real estate market.Example #1 – You sell your primary (or second) home for a loss when taking into consideration what you originally paid for the home, improvements and the sales costs. Bad news - your home is personal use property and losses from “personal-use property” are not deductible. Thus, there is no tax relief from having a loss on the sale of your primary or secondary home.
Example #2 – You purchased a residential or commercial property as a rental. Now the value has declined below your basis and a sale will result in a loss. Since it is business property, the entire loss will be deductible as ordinary income in the year of sale. Thus, you will achieve tax relief based on your tax bracket(s) in the year of sale. Caution: The depreciation of the real property that you claimed as a rental expense decreases your cost basis. This means that you could actually end up with a tax gain on the sale when you thought you would have a loss.
Example #3 – You purchased vacant land for an investment and need to sell it. Unfortunately, the sale will result in a loss. The good news is the loss is tax-deductible, but lacking any capital gains to offset the loss, you will only be able to deduct $3,000 ($1,500 if filing as married separate) of the loss in the sale year; the excess loss carries over to future years.
Example #4 – Your home that you are selling for a loss includes an office from which you conduct your business. The home office is deductible under the income tax rules, and represents 10% of the home. In this case, 10% of the loss would be deductible as an ordinary loss in the sale year. None of the remaining 90% of the loss is deductible due to the personal- use property rules.
Example #5 – Yes, we read your mind. You are planning to move out of your home that will sell for a loss and convert it to a rental thinking you could then deduct the loss. Problem with this strategy is that tax law requires you to use the fair market value (FMV) of the home at the time of conversion as the business basis if the FMV is less than your adjusted cost basis. Thus, the loss in value that occurred prior to the conversion will not be included in your loss when you sell the rental. However, if the market continues to decline, you will be able to take advantage of any future losses.
Example #6 – The property will sell for a loss, so you decide to just let it go into foreclosure. By doing this, you avoid the sales costs but destroy your credit rating for years to come. In addition, if the property sells at auction for less than the mortgage balance, you may, depending on some complicated rules, have to include in your income the difference between the loan amount and the sales price (referred to as debt relief income).
Example #7 – Let’s say you originally purchased your home for $200,000; it increased in value to $300,000, so you refinanced it for $240,000 and used the money to buy a car, go on vacation, pay off credit card balances, etc. Now your mortgage is higher than both your basis (cost) in the home and its current value. Your home sells for $225,000, and assuming you have $10,000 in sales costs, you end up with a tax gain of $15,000 rather than a loss, which may come as a surprise. The gain may or may not be taxable depending upon whether you qualify for the home sale gain exclusion. Bad news is you need to make up the $15,000 mortgage shortage and the $10,000 sales costs.
We strongly suggest you carefully weigh your options before selecting a course of action. A consultation appointment may be appropriate to see what option is the best for your particular tax situation. Please give us a call.