Tax Rules for the Loss of Equity in Your Home

Homes represent a significant portion of most families' wealth.
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Loss of equity in your home is a nightmare scenario for most homeowners. Since your home is usually the single most valuable asset you own and represents a good portion of your personal wealth, even a small percentage decrease in its value can wipe out a good chunk of wealth. Loss of equity in your home is also treated differently from other capital losses by the Internal Revenue Service.

Home Equity

When you buy a home for cash, the market value of the home represents your net equity in the home. A house bought for $200,000 whose going price is now $180,000 represents a 10 percent loss in the value of the asset as well as your equity in it. Since most people buy homes with a mortgage, however, their equity in the home is far less than its market value. Hence, any loss in the value of the asset represents a much bigger percentage loss in the homeowner's equity. In our example, if you borrowed $175,000 and put $25,000 down to purchase the home and must sell it for $180,000, your share of the sales proceeds will correspond to $5,000 after paying the mortgage lender. The $20,000 you lose will equal 80 percent of your original equity of $25,000.

Capital Loss

The loss resulting from the sale of a home is classified as a capital loss for taxation purposes. The IRS classifies any valuable asset, including real estate, stocks, bonds and antiques, a capital asset. Losses from their sale are thus referred to as capital losses. Your capital loss equals your sales proceeds minus your cost base. The cost base equals what it cost to purchase the asset, plus applicable expenses accumulated since your purchase. In the case of a home, the cost of certain improvement projects can be added to the cost base, while others cannot. A capital loss occurs when you actually sell an asset. The mere drop in the market price of a stock is not enough. If you haven't sold the asset yet, the loss has not actualized and is only a paper loss.

Capital Losses from Your Home

In Topic 409, titled "Capital Gains and Losses," the IRS states "Losses from the sale of personal-use property, such as your home or car, are not deductible." Therefore, no matter how large a loss in your equity you suffer from the sale of your home, you cannot deduct this loss against any portion of your taxable income. The decision to sell your home should not depend on your estimated tax liability for the year. When timing the sale of other capital assets, such as stocks, whose associated losses can be deducted from income within certain limits, you should, however, consider the tax consequences.

Taxes on Equity Appreciation in Your Home

While the IRS will not allow you to deduct the loss from the sale of your home, it will tax the gains. The tax authority is somewhat fair, however, as it will forgo taxes on the first $250,000 of the gains. For example, only $50,000 of a total profit of $300,000 from the sale of your home is subject to income tax. Since very few homes appreciate sufficiently to result in such gains, most people do not pay tax on the appreciation of their equity in their homes.

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