Avoiding The Tax Man For Owners Of Homes Sold In Foreclosure & Short Sale Situations

In Palm Springs, California, The Desert Sun reports:

• It has become clear that more taxpayers have debt cancellation income than ever before. As the “Great Recession” heated up this past year, credit card lenders increasingly agreed to accept reduced payoffs from troubled borrowers and forgive the rest. As well, more lenders foreclosed on homes or agreed to short sales. In each case, the borrower has debts that are either partially or entirely forgiven.(1) And under the tax code, debt forgiveness is a taxable event. Ouch. To experience financial upheaval, and then to have to pay tax on top of it all is truly a case of putting salt in the wound. Fortunately, there are several exceptions to the recognition of debt forgiveness as taxable income.

For more, see Debt forgiven, not forgotten by tax season.

(1) It's important to keep in mind that a homeowner that has had his/her home sold in a foreclosure or short sale situation should first determine whether the lender has actually forgiven any of the unpaid debt. There have been a number of published reports that indicate that lenders are increasingly refusing to grant debt forgiveness and, instead, are going after homeowners for the unpaid balance of the mortgage loan in a foreclosure or short sale situation (see, for example, Detroit Free Press: Mortgage, tax bills ultimately come back to haunt walkaways).

If the debt hasn't been forgiven, there is no income tax issue to address; rather, the concern should be on whether (or when) the lender is going to begin chasing the now-ex-homeowner for the balance owed (ie. by garnishing wages, tapping bank accounts, seizing tax refunds and slapping liens on other assets to satisfy the debt).

For those who have obtained debt forgiveness from their lenders and seek information on how to handle the reporting of it (even if the debt cancellation is tax-exempt, the information still has to be reported to the IRS) on their tax forms, consult the following IRS sources:

• IRS Publication 4681: Canceled Debts, Foreclosures, Reposessions and Abandonments,
• IRS Information Release 2008-17: - Mortgage Workouts, Now Tax-Free for Many Homeowners; Claim Relief on Newly-Revised IRS Form,
• The Mortgage Forgiveness Debt Relief Act and Debt Cancellation.

It requires noting that, when receiving a Form 1099 from lenders, the information contained thereon should be checked to make sure it is correct. Whether by intentional malfeasance or merely inexcusable incompetence, lenders have been known to report incorrect information on these forms. See, for example, Foreclosing Mortgage Lender Screw-Up Results In Whopping IRS Tax Bill For Ex-Homeowner.

In conclusion, California residents obtaining debt forgiveness might be subject to state income tax on the amount of debt cancelled, regardless of whether they are legally able to avoid the Federal income tax. See The Sacramento Bee: California tax law unsettled on home short sale.