Foreclosure 'Tax' Is Next Mortgage Crisis

But what happens if you're forced to sell at a loss -- either because of the market conditions, or a job transfer, or because you can't afford to make the payments on an adjustable-rate mortgage?

Under the tax law, your losses on the sale of a home are not deductible! With stocks -- or investment property -- you can offset gains against capital losses, and then carry forward $3,000 a year of losses to write off against ordinary income. But that is not true for losses on the sale of your residence. (And if your employer offers to reimburse you for losses when you sell your home because of a job transfer, those payments are considered income to you, not an offset against losses.)

If you've converted your personal residence to a rental unit, and then sell it as an investment property, you can deduct losses. But you must actually rent it out before getting a deduction. Even worse, you can only deduct the decline in value of the property that occurs after it becomes a rental unit.

The most serious -- and least-known -- tax disaster comes in the wake of a foreclosure. If the bank is forced to sell the property for less than the mortgage (or carries it on the bank balance sheet for less than the amount of the loan), the difference is considered "forgiveness of debt."

The amount of debt that is "forgiven" will be considered income to you in the year of the foreclosure. So you'll receive a form 1099C from the lender, reminding you to pay taxes on that amount at ordinary income tax rates!

Even if you sell your property yourself and pay the bank whatever you can, you have to declare the forgiven debt as income that is taxed at the same rate as your salary.

That's why it makes sense to try to renegotiate your mortgage with your lender. Maybe they can lower the payments or stretch out the term. That way, they don't have to record a foreclosure, and you don't have to pay taxes on forgiven debt.

The president has proposed that Congress temporarily do away with this tax on forgiven mortgage debt. But even if a bill is passed and signed, it may not be retroactive, says Julian Block, author of The Home Seller's Guide to Tax Savings. He advises seeking tax advice before you make a decision about a home you can't afford and might be forced to sell.

Refinancing into a new mortgage with lower payments doesn't have any tax consequences. That makes a new Federal Housing Administration program to help homeowners who fall behind on payments attractive. Called FHASecure, it's designed to let the FHA refinance any adjustable-rate mortgage to a FHA-insured fixed-rate loan if the borrower -- even in foreclosure -- meets the following qualifications:

• A history of on-time mortgage payments before the borrower's teaser rates expired and loans reset.
• Interest rates must have been or will be reset between June 2005 and December 2008.
• 3% cash or equity in the home.
• A sustained history of employment.
• Sufficient income to make an FHA mortgage payment.

For more information call 800-CALL-FHA o go to the FHA's Web site.

The price consequences of a bursting real estate bubble are clear today. Soon the tax consequences will become clear as well. And that's The Savage Truth.