The IRS Doesn’t Take Pity on Home Sellers Who Suffered a Loss

The Internal Revenue Code looks kindheartedly on homeowners who sell at a profit. Internal Revenue Code Section 121 allows sellers to avoid taxes on some – and perhaps all – of their gains on sales of principal residences. The exclusion amounts are as much as $500,000 for married couples who file joint returns and $250,000 for those who file singly or who are married but file separately.
Revised rules allow surviving spouses more time to sell and still qualify for the $500,000 joint-filer exclusion. This break is available to a surviving spouse who sells within two years of the death of his or her spouse, provided the couple jointly owned and occupied their home.
Profits above the exclusion caps are subject to federal taxes, plus applicable state and local taxes. State and local taxes can be claimed as itemized deductions on Schedule A of Form 1040. But the alternative minimum tax completely disallows certain itemized deductibles, including state and local levies, whether on income or on year-round residences, second homes, or other kinds of real or personal property.
Sellers are able to claim exclusions only if they satisfy two key requirements. First, they’ve owned and lived in the property as a principal residence for periods that aggregate at least two years out of the five-year period that ends on the sale date. Second, they haven’t excluded gain on another sale of a principal residence within the two years that precede the sale date.
But Section 121 is one of those trains designed to run in only one direction, authorizing a phenomenal break for those with profits and offering no relief for those with losses.
Back in 1997, Congress and President Clinton cut a deal to exclude profits on sales. They flirted with allowing sellers a limited deduction for losses, but dropped the idea. The final version of the 1997 legislation left unchanged the rule that generally bars deductions for losses on sales of things that are considered personal assets, such as principal residences. And contrary to what many owners mistakenly believe, mortgage debts don’t enter into the calculation of gain or loss on a sale.
Note also that the law empowers the IRS to use its own special method to calculate whether a seller actually suffered a loss. It’s nowhere as simple as, say, comparing the $650,000 you received when you sold your home with the $700,000 you paid for it in 1996, thereby arriving at a loss of $50,000. You’ll need a calculator whenever there’s also a tax-deferred gain from a previous home sale before May 7, 1997, when the current rules took effect. Should that be so, you must subtract the deferred gain from your present home's cost to determine its adjusted basis at the time of sale.
Let's say the place that costs $700,000 was actually your fifth home, and four prior sales generated a cumulative profit of $600,000. The meaning of those numbers: You reduce that place’s basis downward to $100,000 – the difference between the $700,000 cost and the $600,000 postponed profit. Consequently, under the IRS method, the $650,000 sale doesn’t cause a loss of $50,000. Rather, it results in a gain of $550,000 – the $650,000 sales price minus the $100,000 adjusted basis. Suppose, instead, that the only dwelling you’ve owned is the one purchased for $700,000 and unloaded for $650,000. The IRS agrees you do have a $50,000 loss, but one that’s nondeductible.
The IRS and the courts are adamant in their refusal to make any allowances for extenuating circumstances. For instance, an IRS ruling barred 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 matters not that 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 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? 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. The reimbursement counts as income, says the IRS.