Mortgage Crisis, Real Estate Crisis - How Do You Report This On Your Tax Return

We’re almost done with 2008. A lot of investors who were in real estate are going to soon be grappling with one big question: How do I write this all off?

If your real estate went down in value and nothing else happened - you didn’t sell, lose the house or otherwise change your ownership - then life goes on. The investment is reported on your tax return just as it always has been.

If your investments went down in value and you didn’t sell them, then same story. The losses are unrealized (ie, you didn’t sell them or close your position) and so there is no gain/loss to report.

That’s all pretty easy. It gets tricky if you have real estate that you walked away from or was foreclosed on. If you were forgiven of debt on the real estate or, for that matter, forgiven of debt for any reason (credit card restructuring), you have debt forgiveness income. If that real estate was your principal residence, you won’t pay taxes. If the real estate was not your principal residence or the debt was for any other reason, then you will be given a Form 1099 with the amount of debt foregivness on it. This is taxable income to you UNLESS you are insolvent. Now, this is where it gets tricky. What is insolvency?

The strict definition means that you owe more than you own. One way to prove that is bankruptcy. It is assumed that you are insolvent if you file bankruptcy. However, you can go bankrupt with a lot of assets through homestead exemptions and pension plan exclusions. That doesn’t matter. However, if you don’t go bankrupt you have to have more debt than assets and in that case your pension plan and equity in your house DO count. Ironic that you get a much bigger tax break if you declare bankruptcy. Sometimes I wonder what social behavior the government is attempting to foster here.

If you had any other type of loan restructuring, remember the same rules apply. It’s taxable unless you are insolvent.

It’s a little different case with real estate or a real tangible thing that you lose. Let’s say you have a rental property that you paid $200,000 for and it’s now worth $100,000. You walk on the house . You have debt forgiveness of $100,000. But you also have a sale of $100,000 on a property with a basis of $200,000. So there is some offset here. It gets tricky if the property sold/walked away on is an investment property, as opposed to a business property. If it’s an investment, it’s a capital gain property. In that case, you’ve got income of $100,000 and a capital loss of $100,000. On paper they offset, but reality is that you only get to deduct a capital loss at the rate of $3,000 per year.

Taxes will undoubtedly be trickier this year for many people. And that means people who lost a lot already are looking at higher taxes and/or higher tax preparation fees.