Internal Revenue Code Section 121 authorizes phenomenal breaks for individuals who reap profits on the sales of their principal residences. They can sidestep on as much as $500,000 if they file jointly or $250,000 if they file singly.
But what about sellers who suffer losses? Unfortunately, they won’t get any deductions.
Let’s go back to 1997, when Congress and President Clinton decided to authorize exclusions of up to $500,000. While they also flirted with allowing sellers limited deductions for losses, the final version of the legislation didn’t change the rules that generally bar deductions for losses on sales of things that are considered personal assets, such as principal residences.
Complicated rules kick in when individuals unload dwellings they bought before the summer of 1997. In fact, the law empowers the IRS to use its own special method to calculate whether sellers actually suffered losses.
It’s nowhere as simple as, say, comparing the $650,000 seller Abigail received when she sold her home this year with the $700,000 she paid for it in 1996, thereby arriving at a loss of $50,000.
She might need a calculator whenever there’s also a tax-deferred gain from a previous home sale before May 7, 1997, the day the current rules went on the books.
If so, she must subtract the deferred gain from her present home's purchase price to determine its cost basis at the time of the sale. On the plus side, though, her cost basis includes lots more than just the original purchase price.
It also includes what she subsequently shells out for any home improvements, such as renovating rooms, as opposed to routine repairs or maintenance, such as replacing broken windowpanes or papering or painting walls. And there are many costs incurred when buying and selling, such fees for legal advice and title insurance.
An example: Abigail paid $700,000 for a place that was actually her fifth home; four prior sales generated a cumulative profit of $600,000. With those kinds of numbers, an adamant IRS insists that she reduce her current home’s basis downward to $100,000—$700,000 cost minus $600,000 postponed profit.
Consequently, says the agency, Abigail doesn’t lose $50,000 on a sale for $650,000. Rather, she gains $550,000 ($650,000 sales price minus $100,000 adjusted basis). But she then uses her exclusion of up to $250,000 or $500,000 to shrink taxes on her gain.
The IRS doesn’t require Abigail to crunch numbers when she owned only one dwelling that was purchased for $700,000 and unloaded for $650,000. The agency agrees there’s a $50,000 loss, but one that’s nondeductible.
Sellers who incur losses shouldn’t count on the IRS to make any allowances for extenuating circumstances. For instance, it squelched a deduction for a loss caused by a doctor-recommended move from a two-story to a one-story home to allow a child the maximum use of his wheelchair.
It also refuses to allow a deduction when a homeowner is out of pocket because a job relocation triggered by a layoff, illness, death, divorce or the like compelled a sudden sale before a home appreciated sufficiently to offset brokerage commissions, legal fees and the other expenses involved in buying and selling. Likewise, a loss isn’t deductible when you move to take a new job or are transferred to a new location.
What if your employer reimburses you for the loss? There’s still no offset of an otherwise nondeductible loss against the reimbursement because they’re separate transactions. The loss stays nondeductible. Nor is it permissible to include the reimbursement as part of the selling price and avail yourself of the exclusion. It counts as income, says the IRS.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 250 and counting).
About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.