Here we take a closer look at the phenomenon of 1099 Cancellation of Debt income following a foreclosure.
Why Foreclosed Homeowners Receive 1099s for Cancelled Debt
First, the basics: if you owe a debt to someone else, and that debt is forgiven, the IRS Code treats that forgiven debt as income to you. Does it make sense? Sure, because you have just received something that you did not have before. And so, when a homeowner loses a property in foreclosure, banks will typically charge off (forget about) the mortgage loan and simply issue to the former borrower a 1099 for the amount of the loan that the bank forgave. For example, if you bought a house with a $100,000 loan, and the bank received $80,000 in a foreclosure proceeding, that leaves $20,000 to collect from you, the borrower; but read on.
Will I Get Sued for the Loan Balance After Foreclosure?
The short answer: not necessarily. Statistically, you are more like to have the debt forgiven (hence the 1099). In some states the bank has the right to sue you for the $20,000, but the bank might simply forgive the debt. If the bank forgives this debt, the bank will issue you a 1099 for the amount of $20,000–what they do depends on state law (more on this below, and in our article on anti-deficiency) and the circumstances of your individual case. This example is over-simplified, actually, the bank may also include in its 1099 some other goodies for you: expenses, fees, late fees, and whatever other fees originally appeared in your loan contract.
But why would a bank ever forgive the debt and get nothing rather than at least try to collect something? The answer is simple: because by 1099ing the borrower, the bank is declaring a deductible loss that reduces their income tax by roughly 35% of the amount of the 1099. You see, the bank is not likely to have a collection rate as successful as the 35% that they are guaranteed to get by charging off the debt. From the bank’s perspective, it’s simple and sound economics.Two points are worthy of mention: One, in anti-deficiency states, like California, the bank is not allowed to seek the “deficiency” (the $20,000 shortfall in the example above) in most types of foreclosure. Thus, in California you are certain to get 1099ed and not sued. But in deficiency states (the majority of states), the bank can sue you for the deficiency. However, even in a deficiency state, there is still a fairly good likelihood that you’ll be 1099ed and not sued.
I Have Been 1099ed, But I Was Just Foreclosed, and My Financial Condition Is Terrible
Breathe easy, insolvent (broke) taxpayers are not liable for “Cancellation of Debt” (COD) income, generally speaking. However, if you need help with this circumstance, you’ll definitely need to find your own tax professional because the rules are technical.
The applicable Code section is 26 U.S.C. Sec. 108, which provides, in part, the following, “Gross income does not include any discharge . . . of indebtedness . . . when the taxpayer is insolvent” Insolvency is defined elsewhere in the code to mean a simple balance sheet calculation: do your liabilities exceed your assets? So insolvent taxpayers are absolved of the responsibility for enormous COD income hits.
The IRS form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), link here: http://www.irs.gov/pub/irs-pdf/f982.pdf covers this issue exactly, and can give relief to an insolvent taxpayer hit with a huge 1099. Explore this with your tax advisor. The Mortgage Forgiveness Debt Relief Act of 2007 With the so-called “mortgage meltdown” of 2007, the issue of relief from COD income began to gain legislative momentum. There is a bill making its way through the house (as of 10/4/07, it ultimately passed) that would eliminate this entire problem. Keep in mind, this bill passed the house by 386 to 27–rarely does congress agree on anything so unanimously. The proposed law is the Mortgage Forgiveness Debt Relief Act of 2007. It would amend the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred to acquire a principal residence–up to $2 million. It would also set forth rules for determining the allowable amount of the exclusion for taxpayers with nonqualifying indebtedness (rental properties and other loans) and who are insolvent. As of tax-time, 2008, the law is so new that there isn’t even a form available to claim its use.
If faced with such a 1099–get some professional guidance, it’ll go a long way.