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.

Can't win for losing
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 cancelled 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 mortgage property was abandoned, foreclosed, repossessed, or reacquired by the lender.

In all such cases, the resulting income would be taxed at ordinary income rates. With $40,000 in taxable income from debt cancellation, Jim might owe $10,000-$15,000 in tax.

Tax relief for debt relief
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 tax relief.

As you might expect, there are limits to the tax break. For one, it applies only to debt relief from "qualified principal 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 a 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 ($500,000 for couples filing joint returns).

At a loss for tax savings
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 his home to a tenant instead of selling it at a steep loss? He might plan to use the home as 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 conversion 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 an 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's loss would be a capital loss, for tax purposes. He could use that capital loss to offset capital gains, perhaps from stocks he sold. If Jim has no 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.