One of the most common questions I get this time of year is in regards to the IRS form 1099-c that the people who have short sold or foreclosed in the past year will recieve sometime in Janurary.

These 1099's are for Forgiveness of Debt (FOD) when the bank either foreclosed on the property or agreed to a short sale.  In either case, the bank has forgiven debt which then must be counted as income in most cases when the tax return for that year is filed. 

 

There are two notable exceptions to this case.  The Mortgage Debt Relief Act of 2007 provides that as long as the FOD involves the sale of a primary residence or by the exact wording used by the IRS, "your main residence", then the income (forgiven debt) is not taxable up to $2 million or $1 million married filing separately.  It is important to note that this foregiveness is for debt forgiven in calendar years 2007-2012 so  It is very important that the individual file IRS form 982 to deal with this reported income.  Discrepancies between what you file and what 1099's the IRS recieves will usually result in future discussions with the IRS regarding your return.  To qualify, the loan must have been obtained to buy, build, or substantially improve your main home, the home you live in most of the time.  It also must be secured by that home and you cannot have two primary residences at the same.  I could not find this in the literature, but the old definition of a primary residence was that you have lived in it 2 of the previous 5 years.  If anyone knows a different definition, please let me know.

 

 

The other notable exception that does not involve a bankruptcy is insolvency.  The threshold for insolvency is much lower than the threshold for bankruptcy and provides foregiveness of this income.  Basically if the property is not a primary residence but it can be verified that a taxpayers debts exceeds their assets, which may be the case for many investors, then they can exclude the canceled debt through insolvency.  This is pretty complicated so I would recommend a QUALIFIED and COMPETENT CPA for this scenario.  I am not an accountant or an attorney and this article is solely based on my reading of the law and the IRS publications.

 

It should also be noted that the lender cannot pursue you for a deficiency AND issue a 1099 because therefore the debt is not forgiven.  Hopefully, these two exceptions to the rule will apply to most scenarios that are common to our recent housing market but please do not just ignore these 1099s on your tax returns.  If you have a home that potentially needs a short sale, please let us start now so we can ensure we are done by the end of 2012 and avoid these tax consequences at least on the primary residences.