Okay, so misinformation and confusion about the tax implications of foreclosure arising from the cancellation of debt seems to be piling up. In particular, folks seem most confused by the receipt of Form 1099-A from lenders who have taken property back in foreclosure.
First, remember the basic principle: Cancellation of debt MAY result in taxable ordinary income. [Note added 3/31/11: The link is to IRS Publication 4681. This is a 2008 version of this publication, and that as I write this addendum note in March 2011, the IRS has not updated the publication.]
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.
2. Second, if your are “insolvent” at the time that the debt is cancelled (not at the time of the foreclosure, but more on this below) then you will not be taxed. Insolvency is a simple balance sheet test: If your liabilities exceed your assets, you are insolvent. Don’t over think it. 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 I call bankruptcy “the ultimate mortgage modification tool.”)
(Follow the “more” tag below for the rest of this article…The really good stuff.)
So what about this Form 1099-A business? 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. It is a tax neutral document.
The document that causes the problem is the IRS Form 1099-C. This is the one that tells you that the bank has cancelled the debt. It has two effects: First, it can be used as evidence in a later lawsuit by the lender to refute an allegation that the debt is still due and owing. It is not proof; it is just evidence, or as lawyers like to say, it is “probative but not dispositive.” Second, it will likely give rise to the possibility of a taxable event precisely because it constitutes a statement by the lender that the debt has actually been cancelled. (The above exceptions still apply, but how you need to deal with the problem will change.)
Remember: Foreclosure doesn’t per se cancel the debt; it merely satisfies that part of the total debt which is equal to the value of the property.
Here’s the down and dirty of it: You are not likely to receive a Form 1099-C from a foreclosing lender on a recourse obligation because they want to hold out the possibility of recovering a deficiency for as long as they can. (Assuming, of course that the anti-deficiency laws allow it…But that’s a whole different topic that I won’t get into here.) In California, the statute of limitations for breach of written contract is four years. (California Code of Civil Procedure §337) That means that if the lender is not otherwise barred from recovering a deficiency for one reason or another–and in California that is an enormous “if”–then they have up to four years from the time of breach to bring that action. And that, in turn means, that you may not even know whether you have tax problem from a foreclosure until up to four years after the foreclosure. This is simply because there are only three ways a debt is cancelled: Payment by the obligor, voluntary cancellation by the lender or by operation of law. Like because it is time barred.
So since only part of the debt is paid by the foreclosure, and since you’ve only received a 1099-A, without that 1099-C, the claim stays alive until it dies by some other means. Prudent tax pros generally counsel that it is wise to provide some sort of estimated liability if the property has been lost to foreclosure, and you still haven’t received her 1099-C. I tend to disagree with that somewhat, because there is no COD tax until the debt is actually cancelled, and the debt isn’t cancelled until the lender or the law says it is. Estimating the liability based on an assumption that recourse debt will be cancelled eventually may create a need to amend the return later if the lender comes after you. Of course, if the debt is unambiguously non-recourse, meaning that no deficiency is possible, then it makes sense to go the estimate route because the debt is now cancelled by operation of law.
Last, an issue related to this is the difference in bankruptcy dischargeability status between a mortgage debt owed to a lender, and an income tax debt owed to the government. They are not treated the same in bankruptcy: If you owe the bank and you file, then the debt is immediately dischargeable. But if you wait until you have filed the tax return and income tax on the COD (cancellation of debt) is actually assessed, then it is no longer as easily discharged in bankruptcy. Because back income taxes are not dischargeable until two years after the tax return was last due and ten months (approximately…it’s actually 280 days) after the tax is “assessed,” if you wait to file bankruptcy until after you have filed your tax return, you have converted an immediately dischargeable mortgage deficiency owed to a bank into a tax debt owed to the government that you will have to live with through that waiting period before you can dump it in bankruptcy. Capiche?
Because these problems involve the interplay between basic contract law, mortgage and anti-deficiency laws (all of which are state law issues), and 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. This is because no one’s ever lost money on a real estate investment before now. Well, that’s not really true of course, but we are seeing things that are changing history, and testing the limits of most general practitioners. If you think you may have a tax problem arising from a past or pending foreclosure, make sure you seek professional advice from someone who understands the issues. It will vary from state to state, due to the differences in anti-deficiency legislation.