Mortgage forgiveness tax relief differs from home-sale loss

Four years ago, the Internal Revenue Service changed the law that required consumers to pay tax on mortgages forgiven by a lender. Those amounts used to be considered taxable income on a homeowner’s tax return.

The move allowed thousands of borrowers since then to avoid paying tax on short sales or a foreclosure proceeding otherwise known as the “cancellation of indebtedness income.”

According Rob Keasal, a partner in the accounting firm of Peterson Sullivan LLP, the indebtedness relief benefit applies only on a primary residence, not second homes or investment properties, and is limited to the first $2 million of mortgage indebtedness on foreclosures on or after Jan. 1, 2007, and before Jan. 1, 2013.

Refinances made between the time of purchase and foreclosure can cloud the relief indebtedness waters. For example, if you refinanced your loan and took cash out of the property to pay for cars, vacations and other real estate, the amount of your loan when it went into foreclosure could have been far greater than the original debt. The relief limit stops at the amount of the original debt, minus what you have paid in principal. Money borrowed for capital improvements can be added to the original debt figure.

There is no relief or tax deduction, however, for selling your home at a loss.

Most homeowners are now clear on the ability to pocket up to $500,000 of tax-free capital gain ($250,000 for single people) on the sale of a primary residence. The huge benefit, which can be used every two years, was made possible by the Taxpayer Relief Act of 1997.

However, the tax law that provided the capital help did nothing for capital losses. There still is no benefit for folks who bought at the peak or made expensive remodels, then had to sell in a hurry and actually got less for their home than the cash they have invested in it. Long-term capital expenditures usually pay off over time, but changes for the short term are difficult to recover.

If you are hoping for some help on your 2010 return before this year’s deadline of April 18, don’t count on chalking up a capital loss as a big tax deduction. There still is no deduction for a capital loss on the sale of your primary residence. This often causes confusion and provokes questions from consumers, but Uncle Sam will not let you show a loss if you sell for an amount less than the purchase price.

Why? The principal residence has always been viewed as a personal asset. The gain on the sale of a principal residence has been taxable as a capital gain but losses have never been allowed. Although the capital gain thresholds have been increased, proposals to address capital losses have been defeated.

The capital loss proposals first surfaced in the 1990s when complaints from homeowners in the Sun Belt and New England said they were left with huge losses and no federal tax help when home values plunged – especially when the declining oil industry in Texas really shook the housing market around Houston.

Another hotly debated issue is the deductibility of loan fees. You can deduct the loan fees (points) paid to buy or improve your main home in the year of purchase. You cannot deduct these fees in the year you refinanced if you refinanced only to obtain a lower interest rate on your loan.

The term “points” once used to describe only prepaid interest on government loans, now is used to describe charges paid by an owner to secure any mortgage. These points can be loan origination fees or prepaid interest to “buy down” an interest rate. To be deductible, these charges – or points – must represent interest paid for the use of money and must be paid “before the time for which it represents a charge for the use of the money.”

According to the IRS, most points paid when you are refinancing an existing mortgage must be written off over the life of the new loan. For guidance on closing costs, the best source may be the settlement sheet from the original loan.