Bipartisan measure pushes tax relief for `underwater' sellers

Nation's Housing

Those taking a loss face double whammy

May 30, 1999|By Kenneth R. Harney

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 balance? And when lenders forgive the unpaid balance owed on the mortgage, should borrowers then be hit 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 (single taxpayers) or $500,000 (married joint taxpayers) 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-to-$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 job, got sick or suffered some other economic woe -- face worse.

When they sell their homes for a loss, current law not only prohibits them from claiming a capital loss for tax purposes, as they would when they sell stock or bonds for a loss.

But, if they persuade their lender to cancel any balance remaining on the mortgage after the sale proceeds are paid, the tax code treats that cancellation as "income" to the hapless sellers. They get hit with regular federal income taxes on all debt the lender agrees to forgive.

Take this example offered in a "Dear Colleague" letter circulated May 17 on Capitol Hill by Reps. Robert E. Andrews, a New Jersey Democrat, and Mark Foley, a Florida Republican: A homeowner "who has become unemployed might be forced to sell because there is no income to make the mortgage payments," they said. "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 jobless 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 own financial distress, you agree to sell it for $110,000 -- a $30,000 loss. But your loan balance is still $120,000, leaving another $10,000 owed to the bank. As part of "workout" arrangements in cases of genuine distress, many lenders would be willing to simply 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. But the federal government also expects you to pay income taxes, at your regular rate, on the $10,000 forgiven by your lender.

Hit when he's down

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" (H.R. 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 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 1988-1992 -- 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.

Latest price data

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 Los Angeles area who purchased in 1990 is still likely to be in a negative equity position by about 14 percent.

In Hartford, Conn., the comparable negative equity position since 1990, according to First American, is 24.1 percent; in Philadelphia it's 7.1 percent; and in Riverside-San Bernardino, Calif., it's 20.4 percent.

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 under water?

Kenneth R. Harney is a syndicated columnist. Send letters care of the Washington Post Writers Group, 1150 15th St. N.W., Washington, D.C. 20071.

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