No Hard Rule Governs Capital Loss
Q: I am one of those unfortunate souls who purchased bonds of a company that later declared bankruptcy. After waiting about a decade, we have finally received about 10 cents on the dollar as a partial settlement. How should I account for this when I file my taxes? Do I write off the remainder of the investment? What happens if we should get additional payments? Are they considered income? --J.A.W.
A: As we have explained many times before, federal law does not spell out when you can claim a capital loss on a soured investment. The law says only that you may claim the loss when you are “reasonably sure” that you have no hope of recovering any part of your investment. You may reach the conclusion that your investment is completely worthless before a Chapter 11 proceeding is completed. In fact, a bankruptcy filing is not even required.
The call is yours. However, be warned that the IRS can, and often does, challenge these determinations. So you would not want to act too hastily. If the IRS successfully challenges your call, you would be subject to back taxes and penalties. On the other hand, you do not want to wait too long to recognize a capital loss. The statute of limitations on these matters is three years. So, if you wait too long and the IRS rules that you should have recognized the loss earlier, you could lose the capital loss deduction entirely.
As you can see, the IRS requires you to walk a fine line. Our advisers recommend that you take the loss as soon as you have evidence to reasonably conclude that the investment is gone. If you have any doubts, it probably wouldn’t hurt to consult an attorney, accountant or other trusted professional.
Your losses are treated identically under federal and California tax laws. These laws allow you to deduct your capital losses to offset all your capital gains in a given year. If you have any remaining capital losses, you may deduct up to $3,000 per year against your ordinary income. You may continue this procedure annually until the entire capital loss is written off. If you decide to delay declaring your investment worthless, the partial payment you recently received should be entered in your records as a reduction to your taxable basis in the bonds. This new figure is the one you should use when you make the final tax calculations for this investment. However, if you decide to write off the investment now and--by some miracle--you receive an additional payment later, you should include those funds in your taxable income for that year.
No Deduction on Loss From Sale of Home
Q: I am thinking of selling my home and not buying a replacement residence. It is possible that I will sell at a loss. Can I deduct this amount from my previous taxable gains on home sales? --H.D.
A: Losses sustained on the sale of a personal residence are not deductible on your income taxes under any circumstances. If you have carried forward gains from the sales of previous residences, those remain unchanged by the unfortunate--and, in California, rare--occurrence of a residential real estate loss. This fact may give you reason to reconsider your inclination to sell.
Homeowner Wants to Draw Extra Income
Q: I am a widow on a fixed income. I own my home. However, today’s low interest rates mean that my investments are not returning the kind of income I need to cover my living expenses. What should I be doing? I do not want to sell my house and I am not sure I have enough of an income to qualify for a home equity loan. What about a reverse mortgage? --S.C.
A: For starters, you must come to terms with the fact that you may no longer be able to afford to continue living as you have: in your own home with no mortgage. In fact, the best move for you could be to sell your home. Or, it may be that you are able to qualify for a home equity loan. Depending on your age, a reverse mortgage could be an ideal solution.
Your first step should be to contact a trusted, competent financial planner--preferably one specializing in the needs of older people. Ask your adviser to help you understand the choices you face and the consequences of selecting any one of them. Among the factors determining what action is best for you are your age, the value of your home, and the monthly income you need to support yourself.
Let’s add a quick word about reverse mortgages, increasingly a popular choice among older people whose primary asset is their appreciated real estate. Under this program, the homeowner borrows against the equity in his house to gain additional living expense money. However, because these programs tend to deplete the equity of a home very quickly, they are best suited to people who are in their late 70’s or older with a sizable home equity.
For more information about reverse mortgages, contact the American Association of Retired Persons. Send a postcard asking for “Home-Made Money” to AARP Fulfillment D-12894, 601 E St. N.W., Washington D.C. 20049. Delivery takes six to eight weeks. For faster service, you can call the AARP at (800) 424-3410.
No Tax Deferment for Inherited Residence
Q: My aunt has recently inherited a home from a friend. Because the home is bigger and better than the one she has, my aunt wants to sell her home and move into the one she is inheriting. Will the home she has inherited qualify as a replacement residence and allow her to defer paying taxes on the home sale profits she has accumulated over the years? --J.A.
A: Of course not. Your aunt did not purchase the home she wants to move into; she inherited it. In order to qualify for the tax deferral given to replacement residences, a taxpayer must actually purchase a new home with the money he or she has made from the sale of the last.
