Tax question from reader

Question: A year and a half ago, when the market was hot, we purchased a home in El Dorado Hills which we thought would be ours for a long period of time. However, I have just been transferred to the East Coast, and we are now facing a loss when we sell our home. Fortunately, we do not think we will have to come up with cash to sell it, because we put down a large down payment.

If we had made profit on the house, I understand that the IRS would allow us some partial exclusion of that gain, even if we had not owned it for a full two years. Can we deduct all or even a part of our loss?

Answer: Unfortunately, the answer is no. Let's take this example. Your paid $600,000 for your house, and now can only sell it for $550,000. By the time you pay a real estate commission of 5 percent ($27,500) and closing costs (approximately $2,500) your loss will be at least $80,000. The Internal Revenue Code does not allow losses on personal residences.
According to Julian Block, author of The Home Seller's Guide to Tax Savings, "When Congress and President Clinton agreed in 1997 on a profit exclusion of up to $250,000 for sellers who file single returns ... and up to $500,000 for sellers who are joint filers, they flirted with allowing sellers a limited deduction for losses, but dropped the idea. The 1997 legislation left unchanged the rule that generally bars a deduction for a loss on the sale of something that is considered a personal asset, such as a principal residence." There are, however, a couple of exceptions to this rule.

Did you use some of your house for business or rental purposes? If so, that portion can be deducted, since it is not a loss related to a personal asset. Another exception is for principal residences that are converted into rental property. Here is where you may be able to salvage -- or at least limit -- your loss.

Do you need to sell? While many people do not like to own rental property -- especially when they are not physically living nearby so they can monitor the property on a periodic basis -- you should talk with your tax advisors about this possibility.

How does this work? First, you have to remove all evidence that this is still your principal home. Change your drivers license and your voting registration. If you are getting some tax benefit as your main home -- such as the Homestead exemption, advise the County Tax Assessor’s office that you no longer are eligible for this tax reduction.

You now rent out your house. Since you will be living far away, you probably will have to hire a property manager to collect the rent and deal with the tenants. Obviously, this is an additional expense which must be included in your calculations. While you may be willing to have a reasonable yearly negative cash flow, you obviously want to make sure that your income will be able to support this loss.

I believe the market will rebound, but haven't a clue as to when this will happen. Hopefully, within two or three years, the market value of your house will have increased, in which case your overall loss will be less than if you sell it now. And whatever the loss, you may now as a rental be able to deduct it on your income tax return.

You do actually have to rent out the home before you can take a loss deduction. This limitation has been upheld by the courts. It is not sufficient if you just give a real estate agent a listing, or place a "for rent" advertisement in your local newspaper. If you cannot rent the house, you cannot take any deduction for your loss.

The IRS follows what is known as the two year "old and cold" rule. If you rent the house for just one year, the IRS may still consider the house to be your principal residence. However, if you rent for two or more years, your principal residence has now become "old and cold".
Nothing is easy when the IRS is involved. How do you determine the amount of your loss for tax purposes, once you have decided to rent it? According to the IRS, you calculate loss at of the date that you converted the house into rental property. Here is the formula:

· "1. Use the lesser of the property's adjusted basis or fair market value at the time of the change;
· 2. Add to (1) the cost of any improvements and other increases to basis since the change;
· 3. Subtract from (2) depreciation and any other decreases to basis since the change, and
· 4. Subtract the amount you realized on the sale from the result in (3). If the amount is more than the result in (3), treat this result as zero.
The result in (4) is the loss you can deduct."

Good Luck!

Feds hold line on interest rates

While acknowledging that "credit conditions have become tighter for some households and businesses" as financial markets react to upheaval in the mortgage lending industry, Federal Reserve officials aren't ready to slash the federal funds rate.

The Federal Reserve's Open Market Committee voted unanimously Tuesday to leave the key short-term rate at 5.25 percent, saying worries about inflation continue to trump the potential impact of the downturn in the housing market. A statement issued by the committee gave no indication that problems in mortgage lending have shaken that conviction.

The Fed's "predominant policy concern" remains the risk that inflation will fail to moderate as expected, the statement said. "Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information."

Although readings on core inflation have improved "modestly" in recent months, there's no convincing evidence of a sustained moderation in inflationary pressures, the statement said. High levels of resource utilization have the potential to sustain inflationary pressures.

"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," the committee said. "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy."Many housing industry leaders are hoping the Fed will cut the federal funds rate -- the rate banks charge each other to lend money overnight -- to encourage borrowing. The committee will meet three more times this year, with the next meeting scheduled for Sept. 18.