Taxes are making the mortgage mess worse for homeowners

Not only have over 12 million homeowners faced losing their homes to foreclosure or selling underwater homes, commonly due to loss of jobs or business but millions in this situation who sell their homes face still another calamity after a successful sale. They get a big tax bill they can’t get rid of in a bankruptcy to start over, because one must wait at least two or three years after the income return is due or filed.

Even if the house is underwater and the proceeds from the sale to pay off a mortgage and equity line are small, the tax bill can be huge if the house has increased substantially in value from when it was purchased. That’s because the capital gains from a sale are based on the original purchase price plus the cost of any improvements less home office depreciation and the total sale price, less the commission and cost of the sale.

For a person who has to sell a house due to economic conditions and can’t buy another house, where any taxes are rolled into the purchase of the new house, it seems like adding insult to injury – you sell to avoid a foreclosure and eviction, only to be hit by a big tax bill. It’s like hitting someone already down and out with a big board – and the government that is trying to help homeowners keep their homes with mortgage assistance is wielding that board.

That’s what I discovered when I sold my home in Oakland in May 2012. I felt I had little choice, since I was down to my last $500 in the bank and had nearly maxed out my credit cards after the Bank of America, Wells Fargo, and CitiCard reduced my credit by $40,000, though I had been paying my monthly credit card bill regularly.

I had already experienced the mortgage modification nightmare of repeatedly sending in paperwork that got lost or transferred to someone new for nearly two months, when a real estate agent I knew offered to sell my house and found a buyer within a few days. It seemed like the perfect way out, since I would gain about $60,000 from the sale, enough to pay for a rental in San Francisco with 6 months of rent in advance, since my credit was shot from the default. Then, I figured I could start turning things around and build my business back up again.  What I did not realize is that I would get a $40,000 tax bill a year later, after gaining a very small profit from my house after paying off my mortgage and equity line, since my house had inflated in value after nearly 17 years.

In turn, that experience led me to look at the tax and bankruptcy laws that affect millions of homeowners who have been or are in a similar situation, where they are facing foreclosure and eviction, are considering bankruptcy, and have lived in a house with a much higher value than when they purchased it.  They could suddenly be hit with a very big tax bill which they can’t pay after they sell their house, and then have to rethink any plans for going bankrupt and getting back on their feet right away, because they will be facing this tax bill for at least 2 to 3 years.

The basic rule for the sale of a home is that an individual can exclude up to $250,000 in profit from the sale of a main home (or $500,000 for a married couple) as long as he or she has lived there for at least two years, with some exceptions, such as moving due to a change in employment making one unable to meet basic living expenses – a problem affecting many due to the great recession.

Then, the gain one can exclude is the prorated number of months one lived in one’s home.  According to William Perez in “Sale of Your Home: Capital Gains Taxes,” the basic formula for calculating the cost is the purchase price, plus any purchases costs, such as title fees and real estate agent commissions, improvements, such as a new roof or furnace, the selling costs, less the accumulated depreciation, such as the use of an office for a home deduction.  Then, your profit is the selling price, less the cost basis and the exclusion for an individual or married couple.  The tax is based on that – a law in place since 1997.

Now that formula can be fine for someone who bought a home recently, so there hasn’t been much inflation and the $250,000 or $500,000 exclusion can take care of any profit. But if someone has lived in their home for a long time – say a decade or more, there can have been substantial inflation in its value, so even though it is underwater and an individual has to sell due to an inability to pay a mortgage, he or she can face a substantial tax bill and can’t pay that either. Then the bill can prevent the opportunity to go bankrupt and start again free of past debts, since the taxes remain for two or three years.

The basic rule for discharging a federal income tax debt is that you have to meet five basic conditions: The taxes have to be income taxes, there can be no fraud or willful evasion, the debt must be at least two to three years old, depending on when the return was originally due or filed, and the debt must have been assessed by the IRS at least 240 days before filing your bankruptcy petition or not assessed yet.

In short, for a great many homeowners selling their homes due to the mortgage meltdown, the seeming victory of making a small profit or even just breaking even may be short-lived – because then the tax man cometh with another debt one cannot discharged in a bankruptcy for at least two or three years.  And it seems like an unfair double whammy – striking a beleaguered ex-homeowner when he or she can least afford to take on any more debts.