It feels like another kick in the teeth: You lose a home or rental property in a foreclosure or short sale, get a Form 1099-C from the mortgage company, and now you have to pay income taxes on it, too? Like a lot of things in the law, it depends.
It’s a curious, but absolutely-settled principle of tax law, that a debt that is forgiven by a lender becomes taxable income to the borrower. Basically the accounting works like this: When you took out the loan it’s not considered income because you have an obligation to pay it back. When, however, that obligation is removed, you become richer by the amount of debt that you will not have to pay, and the tax law says that must be recognized and you must pay income taxes on it.
Unfair, you may say, but it’s the law. In late 2007, federal lawmakers decided to give SOME relief to taxpayers losing personal residences and changed the law so that the resulting income could be excluded from income tax, if the forgiveness (also known as “cancellation in indebtedness” and
“cancellation of debt” (“COD”) income) meets key requirements:
- The mortgage debt was for a principal residence (that is, the property was the taxpayer’s “home” under the law) and,
- The mortgage debt was the original loan used to purchase the home, or, if the loan was a refinance of the original loan, the proceeds from the refinance were used to make improvements to that property.
Note that the author of this blog emphasizes the term “some” because there is a lot of misinformation out there, probably propagated by commission-hungry, short-sale realtors, that there is a blanket exclusion from COD income for all primary residence mortgage debt forgiven in short sales (or foreclosures, which, for the tax law, are functionally the same).
Nope, doesn’t work that way. If the loan was a refinance or second mortgage where part of the proceeds was used to pay off car loans, credit cards, take vacations, etc., those proceeds will NOT qualify for income tax exclusion under the tax law.
Your tax preparer will need to fill out Form 982 and see if the COD income reported to IRS on the Form 1099-C can be excluded under the exceptions available. Our DC-based tax and bankruptcy law firm has prepared an guide to the tax effects of foreclosures and short sales explaining the issue.
One of the most important exceptions is the “insolvency” exclusion. You can exclude the COD income from taxable income to the extent your net worth calculation shows you are insolvent.
If you use that exclusion, it’s a good idea to keep the documents you use to calculate your net worth. Generally, the government has three years to audit your tax return. Values of assets and debt balances can change significantly in the interim and determining them years later will be impossible.
Remember, finally, that a discharge in bankruptcy avoids the tax issue entirely. So, if you’re not sure the lender will forgive the debt after the foreclosure, or if you know the debt will be forgiven but are unsure or worry about the tax consequences, you may want to consider that option.