You Walk Away... And Finally the IRS Will Let You Go

In our previous article You Walk Away... But Taxes Can Bring You Back, we wrote about how foreclosure can actually put you in a bigger hole. Basically, the scenario goes like this.

• You go into foreclosure.
• The bank forgives some of your mortgage debt (since you can't pay it).
• The IRS is notified at the end of the year by the bank that they took a capital loss on your mortgage (since they gave money away by forgiving you).
• They tie this "forgiveness of debt" to you and you get hit with a tax bill because this is money that you're basically gaining. It's one less debt on your plate, making your net worth better.
• AND, you wind up owing the IRS mucho money as you become homeless. May I be first to say what the (beep)?

Luckily the government has put in place an act to rectify this loophole.

The Patch

If you got some portion of your mortgage debt forgiven, the mortgage company will send you a form 1099-C. If you receive this form, you must fill out a Form 982 (which is now available for electronic filing) and include it with your 2007 return. The same goes for the 2008 and 2009 filing years. This will prevent you from owing on that debt.

The Restrictions

• The balance on your loan must be under $2 million, or $1 million if you file married jointly
• Debt forgiven is not for a second home, timeshare, or rental property.
• Debt forgiven is not for a credit card or car loan.

Additionally, debt from refinancing or money used to do home improvements may be eligible, but only up to the old mortgage principal.

Additional Resources

Foreclosure Prevention Act of 2008 by Linda Beale

You Walk Away…But Taxes Can Bring You Back

Most taxpayers are totally unaware of the potential tax bill left behind when they foreclose on their home. In many cases, a homeowner believes that foreclosure might somehow end the financial misery associated with owning a home, but that is just not true. Nine times out of ten, the tax problem associated with a foreclosure results from the the lender forgiving some of the loan. This happens when the lender forecloses on the property and sells it for less than the outstanding mortgage. If there is a $100,000 mortgage and the home is only sold for $90,000, guess who is responsible for paying the tax on the $10,000 that was forgiven…that’s right: the borrower. The difference for which the borrower is no longer responsible is considered “cancellation-of-debt income” and is taxable income. Even though you aren't selling the house and the bank is, the IRS views the transaction as if you were the seller. That means in the end, you could owe taxes on the sale. I’m afraid this bad news comes directly from the IRS, via Publication 544:

"If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. ... You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized."

Another simplified example: You borrow $35,000 and default on the loan after paying back only $15,000. If the lender is unable to collect the remaining debt from you, there is a cancellation-of-debt of $20,000, which is generally taxable income to you. Bottom line: you can walk away but taxes bring you right back.

If you wind up owing additional tax and cannot pay it in full, the IRS urges that you request an installment agreement with the agency. Often this process can be difficult and time-consuming. If you need assistance with this process, a tax resolution firm may be your best bet.
-Taxus