'Form 1099' Screw-Up By Sloppy Servicer Leads Cash-Lacking F'closed Couple To Pay Income Tax They Didn't Legally Owe; Lawyer: Not An Isolated Case

In Salinas, California, the Santa Cruz Sentinel reports:

• People whose homes have been foreclosed are now facing another financial shock: a hefty tax bill. William Purdy, a tax attorney with Simmons & Purdy in Soquel, tells the story of a husband and wife who got a first mortgage of $700,000 and a second mortgage of $80,000 to buy a home in Salinas. After the wife lost her job, the couple couldn't make payments.

• The lender foreclosed and said the home was worth a little more than $300,000. The couple then got a 1099-A and 1099-C indicating they had taxable debt relief in excess of $400,000. They went to a tax preparer and learned they owed $30,000. They ended up on a payment plan.

• Two years later, Purdy discovered the couple owed nothing. Both of their loans were "purchase money" loans to buy a house, not a refinance, Purdy said, and the home was their primary residence, so under [California] state law they had no personal liability for the debt and no taxable debt relief.

• "They were literally making payments on a tax they never owed," said Purdy, who gave them the good news just before Christmas. The problem, he said, is the lender incorrectly marked both 1099 forms indicating the couple was personally liable for the debt, and the tax preparer assumed the forms were accurate.

• The couple are not alone in this predicament. Foreclosures have become commonplace, and taxpayers have had debt canceled via "short sales," selling their homes for less than what they owed to escape foreclosure.

• "I am seeing most of the forms mismarked," said Purdy, who blames lenders for the economic crisis.(1) [...] Other tax advisers suggest using IRS Form 982 to reduce taxes from mortgage debt relief. Purdy said the Salinas couple's tax preparer used that tool.(2)

• It does not provide complete relief, and here's why. California sets a limit of $800,000 in home indebtedness for a couple, with the maximum exclusion of $500,000 for forgiven debt.

For the story, see Tax bill after foreclosure can cause confusion (Couple who lost home made payments on a tax it turned out they didn't owe).

(1) See Foreclosing Mortgage Lender Screw-Up Results In Whopping IRS Tax Bill For Ex-Homeowner for another example of this type of loan servicer screw-up filing IRS Form 1099.

(2) The following information from the Internal Revenue Service may come in handy in determining how much income tax may be owed to the Feds, and more importantly, whether a homeowner can qualify for one of the law's exceptions from taxation (ie. exception for taxpayers for acquisition or home improvement debt forgiven on their principal residence if the balance of their loan was $2 million or less, insolvency exception, & bankruptcy exception are the three most common) that will allow him/her to dodge the tax either entirely, or at least partially:

• IRS Publication 4681: Canceled Debts, Foreclosures, Reposessions and Abandonments,
• IRS Information Release IR-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,
• IRS Form 982: The amount of debt forgiven must be reported on this form and must be attached to your tax return.

Those lenders, servicers, etc. who have no clue how to prepare a Form 1099-A or Form 1099-C are invited to peruse the 2011 Instructions for preparing Forms 1099-A & C.