What to do with a post-foreclosure or post-short sale 1099?

So you received a 1099 following the short sale or foreclosure of your home. Now what? The answer will depend upon whether you received a 1099-A or a 1099-C. A 1099-A does not create a tax liability so that form can be put away for future reference. A 1099-C, however, does create a potential tax liability and you need to do something about it.

As you may know, an IRS form 1099 is used to record and report miscellaneous income. Although you have just lost your home or agreed to a short-sale, neither of which deposited money in your bank account, you may nevertheless be liable for miscellaneous taxable income.

This income is known as forgiveness of debt income. Although, you did not receive any cash in hand, you received the benefit of no longer owing a significant debt. Think of it this way, when you take out a loan you receive the total amount of the loan proceeds as a benefit. Because you owe the money back, however, it is not considered income. If any part or all of the loan debt is forgiven, the amount of the loan not paid back is then reportable as income.

For example, if you took out a loan of $150,000 to purchase a home, the bank provided $150,000. If you default on the loan after paying back $25,000 and the lender is able to sell the home for $75,000 but is unable to collect the remaining $50,000 from you, that cancelled debt may be included as taxable income.

As with most rules, there are exceptions. For example, forgiveness of debt income is not taxable if:

1. The debt is discharged in a bankruptcy proceeding. Use Form 982 to let the IRS know.
2. You are insolvent when the debt is cancelled. In other words, your debts total more than the fair market value of your assets at the time when the debt is forgiven. That same Form 982 should be used.
3. The debt is on a non-recourse loan. A non-recourse loan is one in which the lender's only recourse is to retake possession of the home and cannot pursue the borrower for the difference. In an Arizona foreclosure context, most borrowers are protected by the state's anti-deficiency statutes that prevent a lender from pursuing the borrower for the difference between the amount owed on a purchase money loan and the amount the property sold for. This protection does not apply in all circumstances but when it does, the loan is considered a non-recourse loan.
4. Federal law also provides a separate harbor (at least until 2012). The Mortgage Debt Forgiveness Act generally allows taxpayers to exclude income resulting from a discharge of debt on their principal residence.

In order to know whether one of the exceptions listed above, or any other exception, applies in your case, you should seek the advice of a qualified professional. They will be in the best position to advise you regarding your own unique set of circumstances.

Interestingly, although the lender is required by the IRS to issue a 1099 under certain circumstances, receipt of a 1099 does not necessarily mean that the debt has actually been forgiven. So keep in mind that not only do you have a tax form today, a lawsuit may be filed against you in the future.