The housing market landed with a thud in 2009 and the US experienced a rapid rise in foreclosures which, in turn, caused many financial lenders to go bust. An unsuccessful stabilization attempt was made by the Government. Their focus was to provide money to mortgage finance institutions and not to homeowners. In most cases, taxpayers will receive a tax form, known as a 1099-C, if they have had to go through the process of a short sale or actual foreclosure. Because of these instances, the financial mortgage lender is in charge of providing these 1099-C tax forms, and in turn, will not pursue a deficiency judgment. This was said to be great news. With this method, the amount of debt that is discharged is shown as income. Keep in mind that there are always exceptions to the rule.
Below are some of the exceptions to the rules you will encounter.
Exception A – If you have had a foreclosure on your home, box #2 on your 1099-C will have this amount written as a forgiven debt. Under normal circumstances, during the short sale of your house by local authorities, the financial mortgage lender will buy your house from you and then it will become what is known as an REO, also known as Real Estate Owned. The lender’s primary intent is to re-sell the home in the shortest amount of time possible, however in some cases this could literally take months. There is a light at the end of the tunnel, however, the amount of the canceled debt will be at the home’s fair market value, which you can find in box #7 of your 1099-C tax form. This is critical as the amount that differs between the loan amount and the fair market value is the amount you should be concerned about and this amount will be shown in box #2. Please note that if this is your place of principal residence , The Mortgage Debt Relief Act of 2007 states that the amount of the canceled debt is not placed as income to you.
Exception B – If you have had a short sale on your home, this technically means that your home was sold with the approval of your financial lender at a discount rate. For the short sale you will still receive a 1099-C tax form. When calculating your canceled debt, they will use the actual price you bought your home for. Note that if this is your primary place of residence, the Mortgage Debt Relief Act of 2007 states that the amount of the canceled debt is not placed as income for you and a 982 tax form must be prepared.
Exception C – If your discharged debt is rental property or other business debt, the loss of the property will be recorded as a sale. In this case, you will be exempted from calculating the gain or loss. To ensure this is done correctly, it is recommended that you hire an experienced professional to help you deal with debt cancellation.
Exception D – Proceeds from a debt settlement will be excluded from an insolvent buyer to the extent that the liability exceeds the fair market value of all assets. In other words, if you have a debt-to-asset pro-debt ratio, you must choose to omit a specific amount from your income amount. EXAMPLE: If you have a canceled debt in the amount of $100,000.00 and you have $180,000.00 in liabilities and $150,000.00 in assets, you can discharge $30,000.00. This would leave you reporting $70,000.00 instead of $100,000.00.
Exception E – This is extremely essential! In some cases, if you’re married and both names are on the deed, you can get two 1099-C tax forms and be able to pay off the full amount of the debt. This is in lieu of a form made in the name of both persons on the deed. This would be an essential conversation to have with your tax professional. You never want the amount in box #2 to be reported twice on the form.
Exception F – Proceeds from debt discharge will be completely excluded after a bankruptcy discharge.
The details above can help you understand the ins and outs of short sales and foreclosures and the effect they have on your taxes. Knowing the consequences early on helps avoid being caught off guard in the future.
