What To Do When You Get An IRS Form 1099-A or Form 1099-C

By now, many unlucky former homeowners have seen the dreaded IRS "Form 1099-A" and "Form 1099-C" sent out by lenders to persons whose homes have been seized in foreclosure, surrendered through a deed in lieu of foreclosure, or sold in so-called "short sales." This Q&A is intended to help you understand the tax consequences.

- Will I have to pay tax if I do a "short sale"?

First of all remember that, for tax purposes, the IRS treats a "short sale" (or foreclosure or surrender by deed in lieu which are all the same for tax purposes) like any other sale. First, a calculation needs to be done to see if there is "gain" (profit for tax purposes) on the sale. Second, in the case of a "short sale" (or foreclosure or surrender by deed in lieu) another calculation needs to be done to see if there is "cancellation of debt" (COD) income --- taxable income resulting from the lender forgiving the debt.

- Can you give me an example? (Example #1)

Let's take a typical example in today's marketplace: John Doe bought a house as his personal residence in 2006 for $500,000. Now the house is worth only $400,000, but he has a loan balance of $500,000 since he took out an interest-only mortgage. He owns a car worth $10,000 (paid off), and has $1,500 in his bank account, $5,000 in clothing and furniture, and a $3,500 retirement plan (a total of $20,000.) Since he lost his job, he cannot pay the mortgage.

If John succeeds in getting bank approval of his short sale for $400,000 and also gets the bank to forgive the remaining balance of $100,000, he will have "cancellation of debt" (COD) income of $100,000. The bank will report this COD income to the IRS, and to John, on a "Form 1099-C" at the beginning of the following year. (The debt cancelled will show in Box 2.)

- Will John have to pay income tax on that $100,000?

Not in this case. A new federal law was passed which covers debt forgiven during tax years 2007 through 2012. John will not have to pay income tax on COD income of up to $2 million ($1 million if married filing separately).

- What are the requirements?

First of all, the loan forgiven has to be on John's principal residence. It is important to remember that it cannot be on property he holds as an investment, such as rental property.

- What if John had abandoned the property that had been his principal residence and moved into another place?

The law states that if John used the house as his principal residence during any two of the past five years, it will qualify.

- What are the other requirements?

This is very important: To qualify the debt forgiven must be for a mortgage used to "buy, construct, or substantially improve" the property, or refinance the same. If the taxpayer used part of the proceeds of a refinance to pay off credit cards, car loans or for other personal uses, it will not fully qualify under the new law.

- Can you give me an example of a refinancing that fails to qualify under the new law? (Example #2)

Going back to John's example, let's change the facts. Let's say he had originally purchased the house for $300,000, and after it appreciated he refinanced it for $500,000, and paid off the original $300,000, used $80,000 for improvements to the house, and kept the other $120,000 for himself to pay his credit cards, car loans, debts to friends, and also take a vacation. If the lender forgives the loan, $380,000 will qualify under the new law's exclusion, but the other $120,000 will not.

- In that case then, how could John avoid income tax on his COD income?

The law provides for other situations where the taxpayer can exclude COD income.

Among the major ways:

Ø Cancellation of the debt in a bankruptcy case. If John files bankruptcy, surrenders the house to the bank during the case, and cancels the mortgage debt through the bankruptcy (instead of voluntary forgiveness of the debt by the lender) it will be fully excluded from taxable income.

Ø Cancellation when the taxpayer was insolvent. John can avoid COD income to the extent he is insolvent. Let's change the facts in Example #1, and say that John also has $30,000 in credit card debt. In that case, he is insolvent to the extent of $110,000 (asset total of $420,000 and liability total of $530,000). Since John's insolvency of $110,000 is greater than the COD income of $100,000, it is completely excluded from taxable income.

- So there may be tax if it is John's investment property on which the debt is forgiven?

Yes. If the short sale is of non-personal residence real estate, the debt forgiven will not qualify under the new law.

- How much would be due? (Example #3)

Take the facts in Example #1, but this time assume the house is not John's personal residence. In this case, John is insolvent only to the extent of $80,000. (Asset total of $420,000 and liability total of $500,000). The COD income (the amount forgiven) would be $100,000. Under the insolvency exclusion John could exclude the first $80,000 of COD income, but would have to include the other $20,000 as income on his tax return. Assuming a 25% tax rate, and no other credits, deductions, losses, etc. to reduce his overall tax, he would owe an additional $5,000 that year.

- What about the other part of the determination for tax purposes you talked about at the beginning?

Going back to our first point, in this type of transaction, a calculation must be made to determine "gain" (profit for tax purposes). This is done by subtracting "tax basis" from "amount realized" to get the difference.

- How is this calculated?

Let's take the facts in Example #2. Say that this is a typical residential mortgage with a "recourse" note (where the taxpayer is personally liable). John's "amount realized" is his sales price, $400,000. His "tax basis" is $380,000 ($300,000 original price plus $80,000 in improvements). The difference between the two is $20,000. After the sale, John has "gain" of $20,000.

- Will John have to pay income tax on that "gain"?

Not in this case. Because this is his personal residence, under the law he can exclude up to $250,000 of gain from income tax from its sale.

- What if the house is not a personal residence but one of his rental houses?

Now, that gain will be includable in his taxable income and he may have to pay capital gains tax on that amount. Note that if part of the gain is attributable to "depreciation recapture" (reduction in tax basis because of depreciation deductions taken in prior years) that will be taxable at ordinary income rates. At a 25% tax rate, for example, John would have an additional $5,000 in tax at year's end. What makes this income tax particularly onerous (and "unfair" in the mind of most people) is that John will have to pay tax to the government in cash on "phantom income" he never had in his hands during that year.

- What tips do you have?

Keep in mind that "one size does not fit all." The new law does not apply in all situations. If the debt to be forgiven is not the original loan used to purchase, but a refinance, you will need to check how the proceeds from the last refinance were used. Be aware also as to the type of property that is the subject of the short sale. If it is not the principal residence, the new law will not apply. Finally be aware that other exclusions may be applicable. However to determine what exclusions are available one must gather the facts, get the numbers and run the calculations.

The article is intended solely as a general guide and not specific legal advice. Contact a qualified tax profession to discuss your particular situation.

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