Law Would Protect Home Seller From Tax on Loss

WASHINGTON —  After several years of radical tax-cutting, Congress is confronting a policy dilemma over who should--and shouldn’t--pay federal taxes when they sell their homes.

The issue is this: Should the government, which now treats virtually all profits from selling a principal residence as tax-free, continue to squeeze taxes out of the least fortunate sellers, those who have no profits at all?

Should federal tax policy penalize home sellers who sell for such a sizable loss that they can’t even pay off their remaining mortgage balances? And when lenders forgive an unpaid balance owed on a mortgage, should borrowers then be whacked with federal income taxes?

A new bipartisan bill in the House asks Congress to answer those questions with a resounding no.

Under current tax rules, most sellers pay nothing on their profits. As long as they’ve owned their property for two years and used it as a principal residence, they can pocket up to $250,000 (for single taxpayers) or $500,000 (for married joint-filers) in profits tax-free.

Just about the only people who now have to pay taxes are at the extreme opposite ends of the spectrum:

* The biggest winners--those whose resale gains exceed the $250,000-$500,000 limit--must pay capital gains taxes on the excess.

* The biggest losers--those who mistimed the market, bought in the wrong location, lost their jobs, got sick or suffered some other economic woe--face worse.

When they sell a home for a loss, current law prohibits them from claiming a capital loss for tax purposes, as they would when they sell stock or bonds for a loss.

But if an owner convinces a lender to cancel any balance remaining on the mortgage after the sale proceeds are paid, the tax code treats that cancellation as “income” for the hapless seller. He or she gets hit with regular federal income taxes on all debt the lender agrees to forgive.

Take this example offered in a “Dear Colleague” letter circulated on Capitol Hill May 17 by Reps. Robert E. Andrews, D-N.J., and Mark Foley, R-Fla.:

A homeowner “who has become unemployed might be forced to sell because there is no income to make the mortgage payments,” they wrote.

“If the proceeds are insufficient to pay off the mortgage, the lender might forgive the shortfall--particularly if there’s no possibility of recovery from the unemployed homeowner. Although the homeowner has lost a home, as well as all equity investment,” the government demands taxes on the amount forgiven.

Say you buy a condo for $140,000 with a $125,000 mortgage. Because of a depressed market and your financial distress, you agree to sell it for $110,000, a $30,000 loss. But your loan balance is still $120,000, leaving $10,000 owed to the bank.

As part of “workout” arrangements in cases of genuine distress, many lenders would be willing to take the $110,000 sale proceeds and forgive the $10,000 remaining.

But what happens to you?

Not only have you suffered a loss of $30,000 that you can’t treat as a capital loss for tax purposes, the federal government also expects you to pay income taxes, at your regular rate, on the $10,000 forgiven by your lender.

Talk about hitting somebody when he’s down.

Andrews and Foley consider this unjust and want Congress to pass their Mortgage Cancellation Relief Act of 1999 (HR 1690) to correct it. The bill, likely to attract support from both parties, would provide a tax-free exemption for any amount a mortgage lender forgives on a principal home sale, provided the sale proceeds are insufficient to pay off the loan balance.

In today’s booming economy, are there large numbers of people with so-called “underwater” mortgages--loans larger than the current value of the homes they helped finance?

Real estate experts say there are far more owners facing this than you’d imagine. Although markets are flush in most parts of the country, hundreds of thousands of people purchased houses during the last peak in the market--roughly 1988 to 1992--in dozens of communities in Southern California, wide swaths of the Northeast, portions of Florida and elsewhere. They’re still sitting on them, often with underwater mortgages.

The latest price data from First American Real Estate Solutions, a California-based firm that tracks home values nationwide, reveals that a typical homeowner in the L.A. area who purchased in 1990 is still likely to be in a negative equity position by about 14%. In Riverside-San Bernardino, the negative equity position since 1990 is 20.4%. A good number of these homeowners may owe more on their loans than their homes are worth.

Looking ahead, who can say that the sales prices of high-flying, inflationary 1999 may not turn out to be the next peak in the market, leaving future home sellers facing stiff federal taxes if they have to sell while underwater?