How to deduct a loss on the sale of your home, avoid debt extinguishment income in foreclosure and deal with abusive mortgages

Traders and others should start focusing on tax and legal planning in connection with declining real estate values and (predatory) mortgages.

Learn how to convert non-deductible losses on the sale of your home into ordinary loss tax deductions.

If you face foreclosure, learn how to avoid phantom taxable income on debt extinguishment by claiming insolvency.

Finally, did your bank or mortgage broker sell you a fraudulent mortgage that was the worst available product and can you get it fixed, without incurring too much pain? Read the NY Times Sunday 8/26/07 expose article on the (predatory) unsavory sales practices at Countrywide (the largest mortgage broker). Countrywide promised the “best” mortgage product, but highly compensated their brokers to instead sell customers the “worst” mortgage product. Isn’t that fraud?

Convert non-deductible home sale losses into ordinary and capital losses
There is a nasty flipside to the tax-beneficial rules of owning your principal residence. Yes, the capital gains are tax-free until you exceed the home sale exemption amounts: $250,000 for single status and $500,000 for married filing joint status.

But tax losses on the sale of your home are not allowed! Few taxpayers realize this unfortunate tax fact until it’s far too late.

If your real estate is not your principal residence, it can be deemed an "investment property" and normal capital gains and loss rules apply. But then the dreaded capital-loss limitation of $3,000 comes into play. Add stock losses with declining markets to the mix and you are again stuck with unutilized losses.

We saw a huge housing price correction before, in the late 1980s and early 1990s. Here's a nifty tax planning strategy that worked well then and should work great again now in this correction:

Rather than incur a non-deductible loss on the sale of your principal residence, convert your home to a rental property first (a short period of time can work) and then incur an (allowable) ordinary tax loss on Form 4797.

There are some nuances to this tax strategy, so check with an expert (such as our firm). When you convert your property to a rental property (income-producing use), you are supposed to use the lower of cost or fair market value (FMV). But FMV on an illiquid and unique home is not readably available, so there is some leeway here.

Avoid phantom income taxation in foreclosure
If you can't pay your mortgage and you suffer home foreclosure, understand that you will be given a Form 1099 for debt extinguishment income from your lender. That's taxable income on your tax return.

But there is a way out of this income. If you are financially insolvent (negative net worth) at the time of debt extinguishment, you don't have to report that phantom income. Many who face foreclosure are probably insolvent.

Demand that your broker and bank fix your mortgage
After you read the NY Times article on the alleged wide-scale abusive sales practices of Countrywide, you should examine your own mortgage loan terms carefully and consider engaging an attorney to help you. I am guessing these types of abusive lending practices are more widespread and not unique to any one mortgage broker.

Don’t think the term “predatory” only applies to sub-prime mortgages for lower income people. Reports of wide-scale lending excesses based on poor credit and highly risky loan terms (zero down payments) seem to support the position that abusive mortgage sales practices were used by many providers across the board, especially if the underlying loans could be repackaged as mortgage-backed securities and sold to unsuspecting investors. This process took the cooperation of several (knowing and perhaps conspiring) banks and brokers.

In my initial view, many mortgage holders can probably engage an expert to review their mortgage terms to hunt for conflicts of interest, compensation tied to selling them the inappropriate terms and other abuses.

These types of abusive lending practices seem very worthy of wide-scale legal attack by consumers and regulators (who are charged with protecting consumers). Maybe it’s not on the scale of asbestos and tobacco, but it’s still very important to millions of families. Fraudulent lending practices may not kill you from a health standpoint, but over-burdening fraudulent mortgages are destroying many people’s finances, which can go on to ruin families and health. Will families have to cancel health insurance to pay for fraudulent mortgage interest-rate hikes and endless fees?

I don’t think everyone should just pay for these abusively generated mortgages without a fight first. Will judges award home deeds to (perhaps fraudulent) abusive mortgage holders in light of this fiasco? I imagine that several law firms will start class-action lawsuits against these mortgage brokers and banks soon to get to the bottom of these abusive lending actions. Many mortgage brokers that have not already succumbed to market changes will go out of business to avoid this onslaught. In my view, this is Enron-like, only on a much bigger and wider scale.

If attorneys do attack mortgage brokers, don’t you think it’s “catching a falling knife” to buy mortgage lenders’ stocks now? Don’t misinterpret recent investment and loan support from larger banks to distressed mortgage brokers; that may be an effort to constrain legal attacks away from their own borders. Again, the mortgage brokers cooperated closely with other banks to package and sell these mortgage-backed securities based on carefully constructed excess (rather than reduced) risk. Isn't that a conflict of interest, too? Shouldn't the cooperating banks try to assemble lower-risk securities, rather than building excess risk? If the securities fail, shouldn't the seller of the securities be liable for the losses if they built in excess risk on purpose and did not disclose it (just to get more fees for themselves)?

This mortgage meltdown story is getting bigger, not smaller, in my view. I fully support the Federal Reserve Bank for adding liquidity and lowering the discount rate. In my view, that is putting out financial market fires (that can burn everyone), and that’s not a moral hazard. But it will be a moral hazard for regulators to interfere with (coming) legal attacks on mortgage brokers and banks that participated in these alleged abusive sales and business practices.

Here’s the bottom line:
If you have a brewing loss on a recently purchased home, consider converting it to a rental property, so you can deduct your loss for tax purposes. If you can’t pay your mortgage and you get foreclosed, don’t get hit with a tax bill on that phantom income by reporting insolvency. If you think you were subjected to abusive lending practices and you face high adjustable interest-rate hikes plus fees, seek legal help before proceeding.

Feel free to contact our firm for help. We can help plan and execute the above tax strategies. We can also refer you to legal counsel, although we don't know any law firms that have taken on this challenge yet.

Robert A. Green, CPA & CEO