Tax laws, when it comes to debt being forgiven, are very clear. If you owe a debt to someone and they cancel or forgive that debt, the canceled amount may be taxable. Does it make sense? Sure, because you have just received something that you did not have before. So, when a homeowner loses a property in foreclosure or sells a house via a Short Sale, banks will typically charge off (forget about) the mortgage loan and simply issue to the former borrower a 1099C form for the amount of the loan that the bank forgave. For example, if you bought a house with a $100,000 loan, and the bank received $80,000 in a Foreclosure or Short Sale, that leaves $20,000 to collect.
Fortunately, there is good news for homeowners that purchased a home as far back as 2007. In 2007, President Bush signed off on “The Mortgage Debt Relief Act of 2007” generally allowing taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a Foreclosure or a Short Sale qualifies for the relief. However, the exclusion does not apply if you; either refinanced and cashed in some of the equity or you took out a Home Equity Line of Credit (HELOC). The amount of equity you cashed out will be taxed. Investment homes or second homes also do not qualify.
The provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million is eligible for this exclusion ($1 million if married filing separately).
For those who don’t qualify for Debt Forgiveness, the question then might be:
Will I get sued for the loan balance after a Foreclosure or Short Sale?
The short answer is no, if you live in Minnesota. In MN the bank does not have the right to come after you for the $20,000 “deficiency” if the property goes to Foreclosure sale. If you don’t live in Minnesota, and live in a state that has recourse (can pursue for a deficiency), the bank might simply forgive the debt anyways. Please check your state laws. If the bank forgives this debt, the bank then will issue you a 1099 for the amount of $20,000. But why would a bank ever forgive the debt and get nothing rather than at least try to collect something? The answer is simple: because by “1099ing” the borrower, the bank is declaring a deductible loss that reduces their income tax by roughly 35%. You see, the bank is not likely to have a collection rate as successful as the 35% that they are guaranteed to get, by charging off the debt. From the bank’s perspective, it’s simple and sound economics.
Ok, so you fall in the category in which you will receive a 1099 because the bank foreclosed or you sold your house via a Short Sale. Breathe easy, insolvent (broke) taxpayers are not liable for “Cancellation of Debt” (COD) income, generally speaking. However, if you need help with this circumstance, you’ll definitely need to find your own tax professional because the rules are technical. The applicable Code section is 26 U.S.C. Sec. 108, which generally sates that “Gross income does not include any discharge of indebtedness when the taxpayer is insolvent” Insolvency is defined elsewhere in the code to mean a simple balance sheet calculation. Do your liabilities exceed your assets? If so, you may be insolvent. The IRS form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness covers this issue exactly, and can give relief to an insolvent taxpayer hit with a huge 1099. Explore this with your tax advisor.
We hope this posting is helpful in your Short Sale negotiations. If you have any questions, please feel free to contact us at firstname.lastname@example.org or visit us on the Web at www.MNShortSaleInfo.com
Disclamer: This post is only an opinion and not legal or financial advise. Please talk to an attorney or an accountant for legal and financial advise.