Must I include income after receipt of a 1099C from the bank following a foreclosure or short sale?

May 15, 2012 - PRLog -- There is a great deal of misinformation and confusion about the tax implications of foreclosure arising from the cancellation of debt. Taxpayers seem confused by the receipt of Form 1099-A from lenders who have taken property back in foreclosure as well as Form 1099-C following a foreclosure or short sale.  

        First, the basic principle is that cancellation of debt MAY result in taxable ordinary income.   Second, because a foreclosure is viewed as a “sale of property,” if you allow real estate to go back to the lender in foreclosure, and it results in a cancellation of debt, then the foreclosure may be a taxable event.

There are three exceptions:

1.     First, if the property lost in foreclosure is a principal residence-literally the home in which you live-then the cancellation of the debt (“COD”) generally won’t be taxable. This is a result of the Mortgage Forgiveness Debt Relief Act of 2007.  This exemption expires on December 31, 2012.

2.     Second, if your are “insolvent” at the time that the debt is cancelled (not at the time of the foreclosure) then you will not be taxed. Insolvency is a simple balance sheet test: If your liabilities exceed your assets, you are insolvent.  Many taxpayers may meet the insolvency test for these purposes although they might not think of themselves as destitute.  The potential losses on all your upside down properties as well as that decrease in value in your home over the past few years are all taken into consideration. You will have to submit IRS Form 982 with the tax return in the applicable year in order to demonstrate that insolvency.

3.     Third, if the debt is cancelled as a result of a bankruptcy filing, then there is also no tax. (This is one of the reasons bankruptcy is ofter referred to as “the ultimate mortgage modification tool.”)

        Form 1099-A is the form that the lender sends you (and the IRS) that documents that the lender has accepted real property in partial satisfaction of a secured debt. It does not create the tax liability. It is not documentary evidence of cancellation of debt.
     
       The document that causes the real problem is the IRS Form 1099-C.  This notifies both you and the IRS that the bank has cancelled the debt.  It will give rise to the possibility of a taxable event precisely because it constitutes a statement by the lender that it has written off  the debt.  It also allows the bank to take a tax deduction for the write-off.  The foreclosure itself doesn’t cancel the debt; it merely satisfies that part of the total debt which is equal to the value of the property.

       Because these problems involve the interplay between basic contract law, mortgage and anti-deficiency laws (all of which are state law issues), as well as federal tax law, these can be gnarly problems to sort out.  Unfortunately, not many attorneys understand them, and not a whole lot of tax pros either.

WHEN WILL WE ISSUE A TAX OPINION?

       Given the proper set of facts, we may be willing to issue a tax opinion stating that the foregiveness of debt reported on the 1099 is not in fact income and should be excluded by the taxpayer.   Certain transactions may be viewed as the settlement of a bona fide dispute or a bargained-for exchange and this should not properly be considered foregiveness of debt under the Internal Revenue Code and Regulations thereunder.  Of course, it is in the lender's interest to issue the 1099 to enable it to claim a tax deduction.  But that does not mean that the lender is right!  We have had numerous cases where the lender has issued a 1099C because it incorrectly took the position that it was entitled to a tax deduction for foregiveness of debt to the borrower.

       Please feel free to contact us if you have received a Form 1099 from your lender (whether or not you have already filed a return for the applicable tax year, since it may be amended).  We are happy to review the facts of your case and the likelihood of our being able to assist you in issuing a favorable tax opinion as well as the fees involved.  Visit our site at http://www.hiltonwienerlaw.com for more information as well as my blog at http://www.foreclosuredefenselaw.blogspot.com.