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Housing bubble a taxing problem

Updated: May 3, 2013 12:14PM

President Bush is trying to help beleaguered homeowners, and the Fed has been easing credit to accommodate the financial markets. But this mortgage mess is a growing problem that will be exacerbated by more than two million adjustable-rate mortgages about to reset to higher monthly payments in the year ahead.

Unless Congress acts quickly to change tax policy, more surprises will appear next April. If you're forced to sell your home at a loss -- or are foreclosed -- the tax consequences could be costly.

The tax laws on the sale of a home are based on the idea that just about every home is sold at a profit. But if you sell your personal residence at a loss, the tax code offers no solace.

Most people are unaware that losses on home sales are not deductible against ordinary income or capital gains, notes tax expert Julian Block, author of The Home Seller's Guide to Tax Savings available at

Before 1997 changes in the tax law, homeowners could roll the gains on sale of their homes if they bought a more expensive replacement, and get a once-in-a-lifetime exclusion of $125,000 in gains on a sale after age 55.

The law changed on May 6, 1997. Since then, homeowners can exclude as much as $250,000 ($500,000 on joint returns) in gains on the sale of a primary residence -- after living in the home for at least two of the previous five years.

It's not a one-time deal. You again can exclude the gain on the sale of a subsequent residence, after living in it for at least two years. Gains above the caps of $250,000 or $500,000 are taxed as capital gains even if you buy a costlier replacement. But what happens if you're forced to sell at a loss because of market conditions or a job transfer or because you can't afford payments on an adjustable-rate mortgage?

Under the tax law, your losses on the sale of a home are not deductible! Investors can deduct part of their losses against income, but not homeowners who incur a loss on their home.

The most serious -- and least known -- tax disaster comes in the wake of a foreclosure.

If the bank is forced to sell your property for less than the mortgage (or carries it on the balance sheet for less than the amount of the loan), the difference is considered "forgiveness of debt."

The amount of debt that is "forgiven" will be considered income to you in the year of the foreclosure. So, you'll receive a 1099C from the lender, reminding you to pay taxes on that amount at ordinary income tax rates!

That's why it makes sense to try to re-negotiate your mortgage with your lender. Maybe the lender can lower the payments or stretch out the term. That way, it doesn't have to record a foreclosure, and you don't have to pay taxes on forgiven debt.

The president proposed Congress temporarily do away with this tax on forgiven mortgage debt. But even if a bill is passed, it might not be retroactive, Block said. He advises seeking tax advice before you make a decision about a home you can't afford and might be forced to sell.

The price consequences of a bursting real estate bubble are clear today. Soon the tax consequences will become clear as well. And that's The Savage Truth.

Terry Savage is a registered investment adviser.

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