Do You Owe Income Tax On Your Foreclosed Home?

March 12, 2013

Going through a foreclosure is a long and unpleasant experience for too many people. Unfortunatley, just when you think the process is over, you receive a letter in January from your former mortgage lender which includes an IRS form 1099-C. Wasn’t this matter settled months ago? Am I supposed to now pay tax to the IRS?

Perhaps not. The Form 1099-C is issued whenever a lender cancels more than $600 of debt. Debt forgiven is treated as income earned by you, but you may qualify for an exclusion if the debt was a mortgage on your primary residence.

There are two ways you can receive cancelled debt on your primary residence.

First, A lender may cancel debt after a forclosure sale which does not raise enough to pay the mortgage off 100%. Rather than pursue the former homeowner for the left over balance, the lender writes it off, and issues the 1099-C. For example, a home sells for $100k when there is a $150k mortgage resulting in $50k of cancelled debt.

Second, a lender will also issue a 1099-C when it simply agrees to restructure and reduce a mortgage by cancelling part of the debt. For example reducing a $150k mortgage to $100k, would result in $50k of cancelled debt.

If this situation sounds familiar, here are a few steps to follow to determine whether you qualify for the exclusion:

1. First, make sure that the form is correct. The value of the home is listed in Box 7. The amount of the debt cancelled is listed in Box 2. If there is an error, contact your lender immediately and request a corrected form.

2. Next, make sure that mortgage secured your primary residence. A second home, business property, or rental property will not qualify. Secured car loans or equipment loans will not qualify. Credit cards and other unsecured personal loans will not qualify.

3. Was the mortgage for the original purchase of your primary residence? If so you may qualify for the exclusion. However, if the cancelled debt was a refinanced loan, you must determine how much of the debt was used to refinance the origianl purchase. If you pulled out equity to pay off credit cards or a car loan, that portion will not qualify for the exclusion and only that portion attributable to the original purchase may qualify for the exclusion. However, if you funded substantial improvements to your home with a refinance, that portion may qualify. It is very important to have good records of your refinance activity.

4. Was the cancelled very debt large? The limit of the exclusion is $1 million. The limit is raised to $2 million for those who are married and file jointly.

5. Review Form 982. There are certain other exclusions available, especially if there was a bankruptcy discharge. Form 982 should be filed with your tax return.

Just because you receive a Form 1099-C does not mean that you will owe tax on the cancelled debt. Make sure you properly address the issue and claim the exclusion when you file your return, or that home may haunt you later. Consult your tax advisor regarding Form 982. Close the books for good on an unpleasant financial experience and look forward towards a brighter tomorrow.