Tax Deduction Considered for Losses From Home Sales

In what could be a life raft for property owners forced to sell their homes at punishing losses, federal lawmakers are considering a bill that would grant a major new tax deduction to Americans caught in that bind.

The proposed tax break would provide a financial cushion for homeowners by allowing them to deduct losses from home sales on their income taxes. The tax breaks would be particularly welcome in Southern California, where residential property values have been falling since 1991.

And it could affect the real estate market in various ways, analysts say, by encouraging home sellers to lower their asking prices or to put on the market properties that they have withheld until now.

“This could be very, very important for Southern California,” said Linda Goold, tax counsel for the National Assn. of Realtors. “We definitely support it. It’s one of those things--how could you not support it?”

The measure passed the House last month with little notice, as part of the sweeping tax-cut package touted by Republicans as a “crown jewel” of their “contract with America.” Its fate is now entangled in the budget debate in Congress, with key Senate members pressing to complete a plan to eliminate the deficit before turning to tax cuts.

Under the proposal, taxpayers would be allowed to deduct up to $3,000 in any one year for their losses and up to the same amount in successive years until the entire loss has been deducted, according to the House Ways and Means Committee.

The provision is not the only obscure item in the tax bill that could have a substantial effect on homeowners in California and other states.

The $350-billion House tax package would cut in half the capital gains tax that homeowners may owe on any profit from the sale of their principal residence. Homeowners now cannot deduct any losses on the sale of their primary residences, as they can with the sale of securities. But, unless they buy a more expensive home within two years, they must pay a capital gains tax of up to 28% on profits.

While these proposals would apply nationally, they have a special significance for homeowners in Southern California, where median prices have fallen as much as 42% since their peak in the early 1990s.

Even as California’s economy began a modest recovery last year, home prices have been weighed down by aerospace cuts and impending military base closures--not to mention the aftereffects of riots, fires and the Northridge earthquake.

The two provisions would save Californians more than $5.3 billion in taxes over six years, according to the nonprofit Tax Foundation in Washington. Nationwide, the measures would wipe out a projected $28.7 billion in tax revenue over six years, though supporters say it would generate other revenue through increased real estate transactions.

Its congressional advocates say that, for all the economic implications, the most fundamental idea is to improve the treatment of homeowners in the tax code.

“It’s a matter of fairness,” said Ari Fleischer, spokesman for Rep. Bill Archer (R-Texas), the House sponsor and chairman of the Ways and Means Committee. He noted that current tax laws may seem stacked against home sellers, saying: “It’s heads the government wins, tails you lose.”

The changes could jump-start moribund real estate markets nationwide, said Steve Murray, co-editor of REAL Trends, a Dallas-based real estate industry newsletter.

“There are thousands and thousands of people trapped in a house in a loss situation without any incentive to get out,” Murray said. “I myself know of half a dozen people in that fix. They’re hung up, stuck there. This would likely enable a lot of them to get out of that situation.” Sales of existing homes, which hit 3.6 million nationwide last year, would probably leap if the bill were passed, perhaps as much as 5%, Murray said.

Few markets could use a surge more than Southern California, which is far removed from the boom days of the late 1980s, when many homeowners saw double-digit annual appreciation in home values.

But those who have bought at high prices since the early 1990s have hesitated to put their homes on the market because they face the prospect of losing money. A sizable tax break, though, might tempt them to sell, said Nima Nattagh, a real estate analyst for TRW REDI.

“It would be a boost to sales because some people would less likely be holding back,” Nattagh said. “It would give them an incentive to enter a transaction. It would be good for anybody in the real estate industry because it would boost the turnover rate.”

But Nattagh said there is a negative side to that increased activity: More homeowners will be willing to dip below their minimum asking price. “This could be a drag on prices,” he said.

Indeed, experts are not at all sure how the intensely personal decision of selling a home would be affected if the proposed tax break were to become law.

“Certainly in Southern California, it would probably benefit quite a few people, but there’s no way to say how many or how much,” said Walter Hahn, an economist with the Kenneth Leventhal & Associates accounting firm in Newport Beach. “People who have to sell their homes [at a loss], whatever the reason, will still do so, with or without a tax break.”

Sen. Orrin G. Hatch (R-Utah), the Senate sponsor of the bill, told his colleagues earlier this year that the package contains “alternative solutions to reform a tax code that discourages investment and unfairly taxes investors on gains caused solely by inflation.”

Sen. Dianne Feinstein (D-Calif.) said she was considering supporting the provision in an April 10 letter she wrote to a constituent. She could not be reached for further comment this week in Washington, where lawmakers are debating budget matters.

Under the home sales measure, a taxpayer who bought a home for $200,000 and sold it for $150,000 would be able to deduct the entire $50,000 loss. The deduction would first be counted toward any capital gains made in the year, with every $2 of loss absorbing $1 of gain.

After that, any remaining losses would be deducted from personal income. However, homeowners would be able to deduct no more than $3,000 in any given year, spreading out any remaining loss over a number of years if necessary.

Albert Clark, vice president of the United Homeowners Assn. in Washington, said the proposal’s distribution of deductions raises some questions.

“What if it’s a quake-affected home in California? Some of those people had to sell their homes at a loss of $100,000--does that mean they can deduct $3,000 a year for 33 years? I don’t think [the Senate] will want to do that,” Clark said. “There are some things that still need to be worked out with this, but we applaud the effort to help out homeowners who take a hit.”

On the flip side, sellers who make money on their homes would in effect be taxed on half of the profit, and at an effective rate lower than the current scale.

For example, a seller who makes $50,000 on a home would have to count $25,000 toward income for the year, with the income bracket deciding the rate they pay on that sum. They would be taxed at an effective rate between 7.5% and 19.8%.

Homeowners now can sidestep capital gains tax on profitable home sales if they buy a more expensive house within two years of the sale. In those instances, tax law allows the seller to defer, or roll over, the gain into the new home.

While the tax-cut proposal before the Senate would not alter that rollover technique, real estate analyst Al Gobar in Placentia said more home sellers might simply pay the lesser tax and never buy that more expensive home.

“They could pay and take the money left over and use it to speculate,” Gobar said. “Cut the rate they pay in half and it would be a disincentive--maybe not a major one, but, still, a disincentive--to buy a more expensive house.”

A senior aide to Hatch said those losses in tax revenue would be partially defrayed by levies pulled in from an increase in home and securities sales, which would produce added tax revenue.

Often, though, homeowners do not sell their properties, but avoid paying capital gains taxes by passing homes on to family members through their wills.

Federal officials estimate that $8 trillion in unrealized capital gains is sitting in houses and other properties that are simply passed on to successive generations. Hatch’s aide said the proposed bills are aimed at encouraging owners to sell those assets, thus providing a “big windfall to the treasury.”

Times staff writer Peterson reported from Washington and special correspondent Boucher from Orange County.