by Benny L. Kass
Question: A year and a half ago, when the market was hot, we purchased a home in Virginia which we thought would be ours for a long period of time. However, I have just been transferred to the West Coast, and we are now facing a loss when we sell our home. Fortunately, we do not think we will have to come up with cash to sell it, because we put down a large down payment.
If we had made profit on the house, I understand that the IRS would allow us some partial exclusion of that gain, even if we had not owned it for a full two years.
Can we deduct all or even a part of our loss?
Answer: Unfortunately, the answer is no.
Let's take this example. Your paid $600,000 for your house, and now can only sell it for $550,000. By the time you pay a real estate commission of 5 percent ($27,500) and closing costs (approximately $2,500) your loss will be at least $80,000.
The Internal Revenue Code does not allow losses on personal residences.
According to Julian Block, author of The Home Seller's Guide to Tax Savings, "When Congress and President Clinton agreed in 1997 on a profit exclusion of up to $250,000 for sellers who file single returns ... and up to $500,000 for sellers who are joint filers, they flirted with allowing sellers a limited deduction for losses, but dropped the idea. The 1997 legislation left unchanged the rule that generally bars a deduction for a loss on the sale of something that is considered a personal asset, such as a principal residence."
There are, however, a couple of exceptions to this rule.
Did you use some of your house for business or rental purposes? If so, that portion can be deducted, since it is not a loss related to a personal asset.
Another exception is for principal residences that are converted into rental property. Here is where you may be able to salvage -- or at least limit -- your loss.
Do you need to sell? While many people do not like to own rental property -- especially when they are not physically living nearby so they can monitor the property on a periodic basis -- you should talk with your tax advisors about this possibility.
How does this work? First, you have to remove all evidence that this is still your principal home. Change your drivers license and your voting registration. If you are getting some tax benefit as your main home -- such as the Homestead exemption in the District of Columbia -- advise the DC real estate tax office that you no longer are eligible for this tax reduction.
You now rent out your house. Since you will be living far away, you probably will have to hire a property manager to collect the rent and deal with the tenants. Obviously, this is an additional expense which must be included in your calculations. While you may be willing to have a reasonable yearly negative cash flow, you obviously want to make sure that your income will be able to support this loss.
I believe the market will rebound, but haven't a clue as to when this will happen. Hopefully, within two or three years, the market value of your house will have increased, in which case your overall loss will be less than if you sell it now. And whatever the loss, you may now be able to deduct it on your income tax return.
Mr. Block gives this warning, however:
You actually have to rent out the home before you can take a loss deduction. This limitation has been upheld by the courts.
In other words, it is not sufficient if you just give a real estate agent a listing, or place a "for rent" advertisement in your local newspaper. If you cannot rent the house, you cannot take any deduction for your loss.
The IRS follows what is known as the two year "old and cold" rule. If you rent the house for just one year, the IRS may still consider the house to be your principal residence. However, if you rent for two or more years, your principal residence has now become "old and cold".
Nothing is easy when the IRS is involved. How do you determine the amount of your loss for tax purposes, once you have decided to rent it? According to the IRS, you calculate loss at of the date that you converted the house into rental property. Here is the formula:
"1. Use the lesser of the property's adjusted basis or fair market value at the time of the change; 2. Add to (1) the cost of any improvements and other increases to basis since the change; 3. Subtract from (2) depreciation and any other decreases to basis since the change, and 4. Subtract the amount you realized on the sale from the result in (3). If the amount is more than the result in (3), treat this result as zero. The result in (4) is the loss you can deduct."
(For more information, see IRS Publication 544, available on the web at www.irs.gov/publications).
You will need your accountant or tax advisor to assist you in calculating the loss, but the IRS does provide a helpful example:
Five years ago, you changed your principal home to rental property. At the time of the change, the adjusted basis was $75,000, and the fair market value was $70,000. This year, you sold the house for $55,000. Over the years, your depreciation was $12,620. Using the formula spelled above, here is how it works:
Lesser of adjusted basis or fair market value at time of change: $70,000
Plus cost of any improvements: -0-
Minus Depreciation: -12,620
= 57,380
Minus amount realized from sale: 55,000
Your deductible loss: $2,380
To complicate things even more, the law also places limits on the amount of the loss that can be deducted each year. According to Block, you can offset capital losses against capital gains. "But in the absence of capital gains, the yearly cap is $3000 ($1500 for those filing separate tax returns) on the amount of losses they can offset against their 'ordinary income'. The law does, however, allow taxpayers to carry forward unused losses to later years."
This "convert to rental" scenario is food for thought, but before you take any steps -- or sign any contracts -- make sure that you have a complete understanding of the complexities of our tax laws. Expert advice is a necessity.
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