Dealing with Residences which have Declined in Value

By Kenneth H. Bridges, CPA, PFS     March 2011

Unfortunately, many of our clients have residences which are worth less than what they paid for them, and in some cases worth less than the mortgage on them.  This is especially true of beach homes and condos. Here are some general rules and considerations.

Loss on sale of home – Gain on the sale of a personal residence (unless it meets the exclusion for gain on sale of principal residence) is taxable, while loss on the sale of a personal residence is nondeductible.  If the residence qualifies as a rental property, however, as opposed to a personal residence, the loss is tax deductible.

Short sale and potential COD income – Selling a home can be very difficult when the amount owed on it exceeds the potential selling price, since the lender must be paid in full at closing.  Sometimes lenders will agree to a “short sale”, whereby the home is sold for less than the mortgage, with the lender not being paid in full at closing. In most cases, however, unless the lender specifically agrees otherwise, you continue to be personally liable for any shortfall. If the lender does agree to forgive some or all of the shortfall, then you have cancellation of indebtedness (COD) income, which is taxable.  If the property is a rental property and you are selling at a loss or if you have “suspended passive losses” from prior years, then you may be able to offset such against the COD income.

Suspended passive losses – If you have incurred tax losses in past years from the rental of the home, then you may have suspended passive losses which will be freed up and become deductible when the home is sold.

Converting from personal use to rental – In order to avoid the limitation on deductibility of loss from the sale of a personal residence, you may benefit from first converting the property to a rental property for a period of time.  However, the conversion to rental status must be bona fide, and you should be aware of a special rule which may require your tax basis in the property to be adjusted down to fair market value at the date of the conversion.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.