One of the advantages of counselling hundreds of upside-down property owners is that I get confronted with situations that may call for solutions outside of what we would normally expect. This is one of them.

A client bought their home for $500,000. Today’s value is at best $300,000 and they owe $340,000.  Because of the economic downturn, they can no longer afford the home and are facing possible foreclosure or a short sale. Generally, we advise owners to stay living in the home as their principal residence to take advantage of the Debt Forgiveness Tax Relief.  However, under our current tax law, an owner cannot take a capital loss on their personal residence. So, my clients would lose the benefit of writing off the more than $200,000 investment they have lost.  In meeting with them, I realized that the amount of taxes they would save on Debt Forgiveness Tax Relief would be approx. 33% on the $40,000 of debt forgiveness, or $13,000. In contrast, the tax savings available by writing off their $200,000 capital loss would be $66,000 but to get this, they would have to turn their personal residence into an investment property.  Since I’m not an accountant, I advised them to check with their tax advisor or a CPA to determine if they could do this and, if so, how it would be done.  But that launched my own investigation which appears to confirm my suggestion.

One internet contributor, www.realestatecolorado.net, identified the key issue as how long one must have the property as an investment (”rental”) to get investment property treatment. They state: “although there is no defined “holding period” to be considered “held for investment,” many tax/legal advisors believe 1-2 years is sufficient barring any factors which contradict an investment intent.”  So, the key is to be intentionally holding the property as investment.  Another resource, The Center for Financial, Legal and Tax Planning, Inc., at www.taxplanning.com/takingacapitallossonyourhouse.html, provides an excellent explanation of the process and similarly concludes: “To cement the property as being a rental, renting the premises for two years should be sufficient to peg the property as a rental.”   So again, it is demonstrating investment intent over time.  The Center also notes: “As well as renting the property, the taxpayer should be cognizant of the little details that the IRS looks to in order to prevent the taxpayer from taking a capital loss.  Such items as having your name on the utility bills, using a regular personal residence mortgage and applying a homestead exemption for local taxes, must be changed in order to cripple an IRS argument that the property is actually a primary residence as opposed to being a rental property.”

Now back to the main question: Can a couple facing foreclosure on their personal residence rent the property out, give up the debt forgiveness tax relief, and get the capital gain write-off?  The answer appears to be “Yes” if they can be convincing that the change was done for investment intent.  It is unclear how the two year intent benchmark is measured, whether that is calendar years or tax return years.  Thus, my clients facing a 2010 foreclosure could theoretically rent their home now and show it as a rental on their 2009 tax return. Then, when the home is foreclosed (or sold short) in 2010, it would appear again as a rental on the 2010 tax return.  Two years showing as a rental on tax returns may be sufficient.  Would the IRS deny investment intent if the property loan is unpaid and foreclosure is forseeable? It is possible.

Certainly, the benefits of making the change could be worth it if successful.. plus you’d get the rental income during the interim.  But don’t take my word as advice to you on what to do . If this appears to be an approach that could benefit you, contact your CPA or tax advisor and get their advice and guidance for your particular situation and rely upon their recommendations. They would have to defend you against an IRS challenge. It certainly is worth checking out further.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com or call us at (916) 966-2260 for a phone or personal appointment.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.