Debt Free

In a move to help homeowners that found themselves in a foreclosure or pre-foreclosure sales situation, the U.S. House Ways and Means committee passed HR3648 through to the floor of the house. The resolution is targeted at alleviating some of the pain felt by many homeowners recently as their adjustable mortgages have done what the homeowners have known they'd do since they signed the loan papers; adjust upward. In this case however, it really does amend a fairly egregious portion of our federal tax code that requires homeowners to treat any part of a mortgage forgiven by a lender as income for tax purposes.

As the tax code stands now, it works like this; your home is foreclosed upon and you owe more than your home is currently worth. This situation is increasingly common in the current real estate marketplace. You have few options in this case. On some occasions the lender will actually forgive a portion of your mortgage and allow you to avoid repaying it, but still consider your loan closed. Say you owed $300,000 on your home, but it's now only worth $275,000. The lender could forgo receiving the $25,000 difference between the selling price of the home and your loan balance. That would obviously benefit you, as you have no money to repay them.

The IRS however, sees that benefit as traditional income and wants to tax you accordingly. So, not only have you lost your home, you now owe the IRS more income tax. For example, you are married and file jointly and earn $66,000 a year. That would put you in the 25% tax bracket ($63,701-$128,500)for 2007. In your case, the IRS would increase your tax liability by 25% of $25,000, or $6,250. It's up to you to come up with that money. Where would you get it? Who knows, but in most cases homeowners in this situation haven't the means to come up with the money.

HR3648 would eliminate the requirement in the tax code that enables the IRS to tax homeowners in that situation. We all know however, like the big corporation they've become, the Feds are loathe to actually give up a source of revenue. This case is no different. In a move that is sure to rise the ire of some, while preserving the “tax the rich, feed the poor” ethos that brings them votes in November, the house has determined that a suitable target to retain the aforementioned revenue is the existing ability of folks with second homes to live in them for 2 years out of 5 and get a capital gains tax break.

As the tax code stands currently you can purchase a home as a second home, as for vacations or retirement, live in it for only 2 years of 5, and get the full $500,000 (filing jointly) or $250,000 (filing singly) exclusion on capital gains taxes. That tax exclusion will be amended to only allow the exclusion for the tie you actually live in the home as a primary residence. If for example, you live in a home now, but purchase a second, smaller home as a rental, planning to sell your current home and move into it upon retirement, you currently can by the home, rent it for 3 years, move into it for 2 years, and in the 5^th year you'll be able to, for tax purposes, ignore up to $500,000 of capital gains.

So, if you bought the new home for $400,000, and 5 years later it was worth $650,000, weather you were filing singly or jointly, you'd not have to worry about paying any capital gains taxes (because the gain was only $250,000) if you had lived in the home as your primary residence for any 2 of those 5 years. If the code is amended you'd only be able to ignore the appreciation occurring over the last 2 years, when you actually lived in the home. So if the home appreciated from $400,000 to $550,000 in the first 3 years, you'd owe Uncle Sam a tax bill for the applicable capital gains taxes on $150,000.

If the bill passes into law (very likely), the committee estimates the Federal Government will reap about $2 billion in revenue per year from the changes. This is more than enough to offset the losses produced by the elimination of the mortgage forgiveness. Considering the increase in foreclosures is temporary, but people will have second homes for the foreseeable future, The Congress has done a nice job at securing additional tax revenue for the government. Goodness of their hearts? Possibly. Sucking more money out of the economy, and your pocket? Definitely.