The problem, however, is that by writing that amount off, the bank is, in essence, giving you the balance of the loan as a gift. You are being told that you don't have to pay it any longer, and the bank will forgive the debt. Good news when your debt is forgiven. Bad news when it comes to taxes. A debt "forgiven" counts as income, and you should expect to get a tax form from the bank showing that you have been "paid" the amount that was written-off. Called a "cancellation of debt", it is provided on a 1099-C form.
Example of Deficiency "Income" Caused by Short Sale or Foreclosure
For example, if you sold a property with an outstanding mortgage of $500,000 for the approved short-sale amount of $350,000 -- there is a $150,000 deficiency. That amount with be credited as income to you at the end of the year -- and you should expect a 1099-C form from the holder of the mortgage. Imagine getting a notice in the mail that you earned an extra $150,000 this year? That's enough to make your stomach turn!
Fortunately, there is relief. The Mortgage Forgiveness Debt Relief Act of 2007 specifically allows short-sales and foreclosures deficiencies to be excluded from taxable income. In order for this be done, the tax payer must file an IRS Form 982. This form is designed to exclude canceled debt from taxable income, and much of the form does not apply to the residential home owner. However, up to $2 million (jointly filing) or $1 million (individually filing) may be excluded based on the sale, refinance, or foreclosure of your principal residence. Be careful with TurboTax! It won't automatically suggest this.
As an aside, there are many other forms of canceled debt that alsoo qualify for exclusion from your taxes. If you have received a 1099-C from your lender (any lender), be sure to consult with a tax attorney (that would be us!) to see if you can safely avoid paying taxes on the canceled amount. Examples of good reasons for this include insolvency, bankruptcy,and farm debt.
Need help with a tax matter? Give us a ring! We'll discuss your case for free on the phone. We have several VA, DC, and MD lawyers who have considerable experience in sorting out complex IRS matters.
Sean R. Hanover, Esq.
The Hanover Law Firm is located in Washington, DC and Fairfax, VA. We practice
in both state and federal courts in VA, MD, and DC.