President Bush's call for a $75 billion economic stimulus package on Capitol Hill could have significant tax-code benefits for real estate and housing. Although few details were provided by the White House regarding the specific contents of the plan, congressional tax experts say one of the "live" possibilities is for an across-the-board reduction in capital gains levies, possibly to 15 percent from the current 20 percent rate.

That would be a big plus for investors in everything from stocks and bonds to income-producing real estate. A small number of home sellers would also benefit from the tax cut because their sale profits exceed the current $250,000 or $500,000 capital gains exclusion limits.

For owners of investment real estate, a 15 percent rate would be "welcome," a top real estate legislative counsel told Realty Times. But far more important would be a reduction in the "recapture" rate -- another possible item in the stimulus package. Under the current Internal Revenue Code, recapture --taxation of depreciation deductions taken during the period of ownership of the property -- is set at 25 percent. Regular capital gains taxation, by contrast, is at 20 percent.

That rate differential can eat away at the net gains investors earn from real estate. As a simplified example, say you bought a property for $100,000 and sold it for $125,000 after 6 1/2 years for $125,000. During that period, you wrote off $18,000 worth of depreciation. When you sell the property, that $18,000 gets tacked onto your gain, pushing it to $43,000 ($25,000 plus $18,000).

Real estate groups in Washington have lobbied periodically for a change in this divergent tax treatment, arguing that recapture should be taxed at the same rate as regular capital gains. The Treasury Department and some Capitol Hill tax committee staff experts have resisted this view, arguing that depreciation deductions are taken against taxpayers' ordinary incomes, and shouldn't be treated as capital gains.

Realty lobbyists are pushing for "recapture relief" to be included in the new stimulus package but aren't confident they'll get it past the key tax-policy "gatekeepers" in the House Ways and Means Committee and Senate Finance Committee. They are also worried by reports that former Treasury secretary Robert Rubin, along with Federal Reserve chairman Alan Greenspan, are privately arguing against any reduction in capital gains rates on the grounds that such cuts could stimulate heavy selling of stocks.

One homeowner-related tax concept appears to be a very solid bet for inclusion in the stimulus: so-called "mortgage cancellation relief" for certain people who sell their houses at a loss.

Under current law, if you have the misfortune to fall seriously behind on your home mortgage, the federal tax system can hit you with a financial double-whammy. Say you sell your house for less than your outstanding mortgage balance, and the lender agrees not to come after you for the unpaid balance. This happens with increasing frequency as lenders seek to avoid costly foreclosures against defaulting borrowers and agree instead to so-called "short sales," where the sale proceeds provide the lender most, but not all, of the debt owed.

As an example, say you bought a house for $150,000 with a $135,000 mortgage. Then you lost your job, couldn't make your monthly payments, and faced the nightmare of foreclosure.But your lender checked what your house would bring at a foreclosure sale, and found that it was just $125,000 -- $10,000 less than you owed on the loan.

After all its brokerage, legal, maintenance and other costs, the lender calculated that it would pocket less than $100,000 from a foreclosure. Instead, as an alternative, the lender suggests a "workout" arrangement: You or a realty broker find a buyer who'll purchase the property quickly at $125,000, and the lender won't foreclose and won't come after you for the $10,000 remaining on the mortgage.

That's great, you say. But then you confront the federal tax code's double-whammy: The IRS sees the forgiveness or cancellation of $10,000 of debt as income to you, and demands taxes on it at your regular tax rate -- even though you actually received no cash income at all. The remedy to this problem being pushed by real estate trade groups would provide a tax-free exemption for any amount a mortgage lender forgives on a principal home sale, provided the sales proceeds are insufficient to pay off the loan balance.

With rising unemployment and widespread layoffs looming in the months ahead, proponents say now is the time to get the debt-cancellation trap for homeowners and lenders corrected, once and for all.

For more articles by Ken Harney, please press here.

Published: October 8, 2001

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.