Congress failed to extend a series of valuable tax credits at the end of 2013, meaning (you guessed it) another set of tax hikes on the horizon. Among the many tax breaks to go extinct alongside 2013, taxpayers will miss the education tax credit, mass transit tax deductions, the state sales tax deduction and others. But there are two that specifically affect homeowners and landlords: the residential energy tax credit and mortgage forgiveness relief.
Of the two, the energy efficiency tax credit is the simpler, so let’s start there.
Through tax year 2013, homeowners who made qualifying energy efficiency improvements on their home earned a tax credit of $500. Contractors were able to claim a tax credit of $2,000 per qualifying home that they built; in tandem, these tax credits were designed to boost both the demand and supply of energy efficiency-boosting upgrades and new construction. But despite the rhetoric from Washington about the importance of reducing energy usage and curtailing climate change, lawmakers are no longer putting their money where their mouth is, where residential energy usage is concerned.
(A quick pause to review tax terminology: a tax deduction is taken from a person’s taxable income, whereas a tax credit is taken directly off of that person’s income tax bill, so a tax credit is far more valuable than a tax deduction.)
The second tax break to go extinct is the Mortgage Debt Relief Act. When a homeowner or landlord sells an underwater rental property through a short sale, or loses a rental property to foreclosure, the IRS has a special way of acknowledging the loss.
They charge taxes on the negative equity (the amount they were underwater), as if it were income.
Perhaps this tax on debt forgiveness is best illustrated through an example. Consider Landlord Larry, who bought a rental property in 2006, in a neighborhood struggling to improve and looking like it might just be on the brink of turning around. Then the housing market collapses, all of the investment dollars that were starting to enter the neighborhood disappear, and the neighborhood sinks lower than ever.
Landlord Larry borrowed $60,000, but now the property is only worth $35,000. After years of uneven rent payments, break-ins and all-too-frequent vacancies, Larry cannot take the frustration anymore and finds a buyer for the market value of $35,000. Miraculously, the bank agrees to a short sale. The day Larry sells and stops the bleeding is a happy day indeed.
Enter: The Internal Revenue Service. They tell Larry that he owes taxes on an extra $25,000 of income: the amount of money the bank forgave on the loan balance (in reality, it would be more like $22,583.98, since the loan would have been paid down some over the years, but that is beside the point of this example). If Larry ordinarily earns a yearly income of $50,000, he will owe taxes on $75,000 of income, even though he did not actually earn $75,000.
The story is similar if Larry’s property were foreclosed upon: if the bank decides not to pursue Larry for the shortage, Larry not only loses the property and ruins his credit, but he also owes a lot of taxes on money he never saw.
Is there a silver lining? Maybe – homeowners were temporarily exempted from having to pay debt forgiveness taxes from 2007-2013, although landlords were not exempted even before the measure expired. A bill has been introduced in the Senate to extend the Mortgage Debt Relief Act, and may or may not pass. Still, the bill only applies to mortgages on owner-occupied properties, so it would only benefit landlords if the mortgage they were trying to reduce is for their primary residence.
Still, homeowners who split their time between two properties and are considering a short sale on one of the properties may want to watch the progress of the Mortgage Debt Relief Act, and make sure that they maintain the short sale property as their primary residence until settlement. It is also possible that the residential energy efficiency tax credit will be reintroduced later this year, although that remains less likely.