INTRODUCTION

In the usual circumstances surrounding the real estate market that have been in play since World War II in this country, houses have generally appreciated in value.  In recognition of this, in 1997, the IRS and Congress created a rule modifying the old home appreciation rule.  Under the old rule, home owners were required to reinvest their gains into another home in order to avoid paying capital gains taxes.  Since the real estate market was stable, and to encourage investment in primary residences, Congress updated the rule in 1997. Under the new rule, any appreciation up to $250,000 for a single person and up to $500,000 for married couples, is now completely tax free under the home sale exclusion without the requirement of a reinvestment.              

Today, as we are all aware, housing values have dropped precipitously around the country.  Most real estate markets have seen at least a 10% drop in value, but declines in value in places such as Florida, Las Vegas, and California are 50% or more.  Some homes in Detroit have lost nearly 90% of their value!!!  The real estate market is quite different from what it was just 5 short years ago.

THE RULES

Most personal possessions owned by individuals do not come with the right to deduct losses when the item is sold.  Items such as boats, vehicles, clothing and other personal items depreciate, yet taxpayers get no deduction for diminishment or loss of value that occurs.  Under ordinary circumstances a personal residence is also one asset that the IRS does not allow the owner to deduct when losses occur.  According to the Internal Revenue Code, under most circumstances, HOME SALE LOSES ARE NOT DEDUCTIBLE.  While this comes as a shock to many people, the rule stands and has not been modified to reflect today’s new reality. 

There is another set of rules regarding capital gains and loses when the capital gains and losses attach to possessions used in a trade or business.  These rules state, generally, that possessions used in a trade or business are subject to gains and loses that are capital in nature and therefore gains are taxable, and losses are deductible. 

Utilizing the latter set of rules, any taxpayer, not only business can take deductions on houses, that is, if the taxpayer falls into or manages to make him or herself fall into this set of rules. 

OPTION 1: RENT YOUR HOUSE

Most home owners occupy their house as their home, as their place to live.  In order to utilize the IRS’s favorable loss treatment, one solution is to start using your house as a rental property.  Rental properties are generally viewed by the IRS as a capital asset and therefore subject to capital losses when a loss is realized and recognized for tax purposes (when it is sold).

As a good rule of thumb, to accomplish this end, the house must be rented out for a length of time prior to sale.  While there is no hard and fast rule as to how long the premises must be occupied in order to be viewed as a rental property as opposed to a primary residence, try to stay away from using a bare bones length of time such as a day or an hour.  To cement the property as being a rental, renting the premises for two years should be sufficient to peg the property as a rental.

As well as renting the property, the taxpayer should be cognizant of the little details that the IRS looks to in order to prevent the taxpayer from taking a capital loss.  Such items as having your name on the utility bills, using a regular personal residence mortgage and applying a homestead exemption for local taxes, must be changed in order to cripple an IRS argument that the property is actually a primary residence as opposed to being a rental property.

The rent paid to the taxpayer, now the landlord, can be applied to the mortgage, while the landlord finds other living arrangements suitable for their new economic situation.  While the rent can be applied for the now rental unit’s mortgage, expenses can be deducted to mitigate this income factor.  Such expenses include depreciation, mortgage interest expense, taxes, and maintenance fees. Once the two year period is up, provided the taxpayer still desires to sell the place and the sale would still be at a loss, the taxpayer is then free to sell the property and deduct the loss on Schedule D with their 1040 which is filed annually every April 15th.  While the losses are limited to $3000 annually, a $15,000 deductible loss is still better than a $15,000 nondeductible loss.

OPTION 2: BUSINESS USE

This option is generally reserved for those who own and operate a business.  This business use option has substantial limits based upon zoning rules and the type of business you have.  If the taxpayer’s profession is that of law, accounting, or some other “light duty” business, the taxpayer can generally use their homes for business in the capacity of an office or home based business.  In this usage, the taxpayer does not always have to abandon usage of the home as a residence, but the residence can be utilized solely for business use if the situation permits while the taxpayer finds other dwelling accommodation. 

When using the house in a business, certain deductions can be utilized as well, including part or all of the utilities, part or all of the mortgage, depreciation, and etcetera.  Once the taxpayer decides to sell the home, part of any loss can be deducted in accordance with the tax rules that apply. 

CONCLUSION

Selling a house at a loss when the old philosophy has been “real estate never goes down in value” is a definite paradigm shift for this country.  Since Congress and the IRS have not caught up to this new reality as of yet, taxpayers must look for and be creative in their tax strategies in order to avoid unfavorable tax and economic situations.