President Bush is trying to help beleaguered homeowners, and the Federal Reserve has been easing credit to accommodate the financial markets. But this mortgage mess is a huge and growing problem that will be exacerbated by millions of adjustable-rate loans that are about to reset, resulting in higher monthly payments in the year ahead.

And unless Congress acts quickly to change tax policy, there are more surprises that will start appearing next April. If you're forced to sell your home at a loss -- or lose it through a foreclosure -- the tax consequences could be costly.

Tax laws on home sales are based on the idea that just about every home is sold at a profit. But if you sell your personal residence at a loss, the tax code offers no solace. It may even penalize you.

Homeowners can exclude as much as $250,000 (or $500,000 on joint returns) in gains on the sale of a primary residence -- after living in the home for at least two of the five years that end on the sale date.

It's not a one-time deal. You again can exclude a gain on the sale of a subsequent residence after living in it for at least two years. Gains above the caps of $250,000 or $500,000 are taxed as capital gains (current maximum rate: 15%).

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.

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Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated, and she released her fourth book,

The Savage Number: How Much Money Do You Need?

in June 2005. Savage was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. A Phi Beta Kappa graduate of the University of Michigan, Savage currently serves as a director of the Chicago Mercantile Exchange Corp. She also has served on the boards of McDonald's and Pennzoil.