Short Sales & Tax Returns

The year 2009 was ground shattering for the housing market. The foreclosures in the country continued to increase exponentially and many lenders went out of business. The government tried unsuccessfully to stabilize the crisis by giving money to the lenders (instead to help homeowners). Many taxpayers will be receiving 1099-C tax forms if they went through foreclosure or short sale. The fact that the lender is sending those 1099 forms means that they are not going to pursue a deficiency judgment. This is good news. Usually, the amount of debt cancelled is considered an income. However, there are exceptions.

1. If your home has been foreclosed on, box 2 of 1099-C will show the amount of debt forgiven. Usually, at the sheriff’s sale, your lender buys the house back and it becomes an REO (real estate owned). The intention of the Bank is to sell the house as soon as possible, but sometimes it takes many months to get rid of it. The good news is that your amount of debt cancelled is based on the fair market value of the house (box 7 of 1099-C). This is important: the difference between the FMV and the loan amount is what matters to you and shows in box 2. However, if it is a primary residence, according to The Mortgage Debt Relief Act of 2007, the amount of debt cancelled is excluded from the income.

2. If you had a short sale, which means that your home has been sold at a discount (with your lender’s approval), you will still receive 1099-C. The only difference in this case is that in order to calculate the debt cancelled the actual purchase price is used. Again, if it is about your primary residence, it is excluded from income (form 982 has to be prepared).

3. If the debt cancelled was a business debt (for example rental property), then the loss of the property results in a “sale”. Therefore gain or loss has to be calculated. Make sure you find an experienced tax professional who knows how to handle cancellation of debt.

4. Income from the cancellation of debt is excludable for an insolvent buyer to the extend that the liabilities exceed the FMV of their assets. In plain English this means that if you have more debt than assets, you have the right to exclude a certain amount from your income. For example, if you have debt cancelled of $100,000. Your liabilities are $180,000 and your assets are $150,000. Your insolvency is for $30,000. Therefore, instead of reporting $100,000 as an income, you will report $70,000 only.

5. Very important. Sometimes, if you are married and you are both on the deed, you can receive two 1099-C forms for the full amount of debt cancelled (instead of one form with both names on it). Point out this fact to the tax preparer. You don’t want the amount in box 2 to be reported twice.

6. Income from the cancellation of debt is fully excludable if the debt is discharged in bankruptcy.

This information is just to help you understand that foreclosures and short sales have tax consequences. This is again about knowing how to play the game.