Tax Consequences of a Short Sale: Dealing with a 1099C

If you are a homeowner going through a foreclosure of Short Sale, it is important that you become well versed on 1099C’s.  This will prevent 2 things:

1.) A Coronary on or before February 2, 2010 when you receive your 1099C.

and

2.) Having to pay taxes on monies that were ‘forgiven’ by your bank in the short sale or foreclosure

Let us first talk about exactly what is a 1099C .  A 1099C is a Cancellation of Indebtedness form that a lender is required to fill out when the forgive a debt greater than $600.  The lender is supposed so send these out to you before February 2 in the year following the discharge of the debt.  Not all cancelled debt is considered a taxable event such as the following off the IRS website:

• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.You are insolvent when your total debts are more than the fair market value of your total assets.Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Certain farm debts:If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Non-recourse loans:A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral.That is, the lender cannot pursue you personally in case of default.Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.However, it may result in other tax consequences.

If your lender does not issue you a 1099C and you have had debt forgiven or discharged in the prior year, you still are required to report this. If you follow the formula under Section 3 on the IRS site you can easily figure out the amount that was forgiven (you may need to call your lender to verify the amount of the payoff prior to the sale).

Here is the good news….

The Mortgage Debt Relief Act of 2007 generally allows 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, qualifies for the relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

More information, including detailed examples and qualifications can be found inPublication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.

So, if you are like me, you may be saying now, “Ok, thats fine and dandy, I understand I don’t have to pay the taxes … but unpack this for me a bit, how do I actually go about doing this?  What forms do I need, what do I fill in the blanks with?”

I’m glad we asked that question, so here it goes.  You need to get yourself an IRS Form 982 and it looks something like this:

Now, if the only debt you are reporting forgiven that you are excluding is due to a foreclosure or short sale then you only need to complete lines 1e, 2 and 10b.  What you do is go back to the 1099C that you received from your old lender and go to box 2 (see below), That number is what you will enter in box 2 and 10b of your form 982.

So, that is pretty much it.  If you have further questions about the check out the following sites:

The Mortgage Forgiveness Debt Relief Act FAQ

Publication 4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments with detailed examples

IRS New Release IR-2008-17

Tax Payer Advocate Service – 1-877-777-4778,

Home Foreclosure and Debt Cancellation (good for figuring out how to calculate your own 1099C income if bank fails to send you one)