Ask Stacy: Will I Have to Pay Taxes Because of a Foreclosed Home?

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It’s hard to wrap your mind around, but sometimes when a loan is forgiven, taxes aren’t.

Here’s this week’s question:

I follow you guys religiously and I am so thankful for your advice. I do have a question about taxes.
I had a foreclosed house last year and my accountant said that the IRS may want me to pay taxes on the loss as if it was a gain. Is this true and how could that be when it can be easily proven that I didn’t make a profit on this house? It was a foreclosure. Please, any help on this will be greatly appreciated.
Thanks and keep up the good work for the little people.
Yours truly — I.P.

When your loss becomes an IRS gain

Nobody has to pay taxes on a loss, no matter the source. What I.P.’s accountant was probably alluding to was having to pay taxes on a partially forgiven mortgage loan.

The rule: While borrowed money isn’t regarded by Uncle Sam as income, if you don’t pay it all back, the unpaid balance is taxed just like income.

Example: I loan you $10,000 and you pay back only $4,000. The day I give up trying to collect and write off the $6,000, as far as the IRS is concerned, I lost $6,000 and you earned it. It’s the same as if you’d won $6,000 in a contest, or at a casino. In short, you’re $6,000 richer, and Uncle Sam wants his cut.

If you owe $10,000 on a credit card debt, negotiate with the credit card company and end up settling it for $4,000, same thing: You just earned $6,000.

If you owe $100,000 on a mortgage, give the house back in a foreclosure and the bank recoups only $40,000, the bank takes a $60,000 deductible loss. As far as the IRS is concerned, that’s $60,000 you earned.

So whenever you pay back less than you borrow, if the forgiven debt exceeds $600, it’s possible you’ll get a 1099-C form in the mail the following January.

If you find yourself facing this misery, at least you’ll have plenty of company. Millions of 1099-Cs are issued annually.

Is it fair?

At first blush, this may seem the epitome of kicking someone when they’re down. After all, I.P. already lost a house, along with the down payment and any improvements. Going after I.P. for taxes on the forgiven portion of the debt smacks of emptying a carton of Morton’s into the wound.

But there’s logic behind this seemingly cruel rule. If no tax were required for forgiven debt, it would be easy to cheat the government. For example, suppose I took a $100,000-per-year job, but asked to be paid in the form of a forgiven loan. Since loans aren’t taxable income, without this rule, I’d be earning $100,000 tax-free.

Of course, I.P.’s situation is much more common than the one I just described. Perhaps that’s why there are exceptions allowing many in similar circumstances to dodge this bullet.

When forgiven debt isn’t taxable

Fortunately for I.P. and millions of other hapless homeowners, since 2007, forgiven foreclosure-related mortgage debt is rarely taxable.

The 2007 Mortgage Forgiveness Debt Relief Act, extended through the end of 2013, specifically excludes forgiven mortgage debt from income. At least, as long as it related to a primary residence, was less than $2 million for joint filers, and, as the IRS puts it, was “directly related to a decline in the home’s value or the taxpayer’s financial condition.”

So if the forgiven debt is home-related, I.P. is probably in the clear, providing the debt was forgiven in 2013 or before.

Here are some other situations where forgiven debt isn’t taxable:

  • If the debt was discharged in bankruptcy.
  • If the debt was forgiven when you were insolvent. This is the strategy used by many with canceled or settled credit card debts. You’re insolvent when what you owe exceeds what you own; in other words, your debts exceed your assets. This doesn’t mean, however, you don’t report it. The forgiveness is nontaxable only to the extent of your insolvency, and you’ll have to fill out a worksheet and file an IRS form.
  • Non-recourse loans. When the lender’s only recourse is to repossess the financed property, that’s a non-recourse loan. In other words, the lender can’t come after you personally. While some real estate fits this bill, car loans almost never do.
  • Some student loans can be canceled in exchange for entering certain professions or performing public service. If they meet the criteria, cancellation of these debts is nontaxable.

Note that qualifying to have your forgiven loan rendered nontaxable doesn’t make it automatic. If you get a 1099-C, so did the IRS. So if you’re entitled to an exemption, you’ll need to include the amount on the 1099-C in your gross income, then file a Form 982 with your tax return to show why it’s not taxable.

The bottom line

The numbers involved in forgiven debt can be big, and so can the tax bill. While you can check out examples and read about it on this page of the IRS website, if you get a 1099-C or otherwise think you may have to deal with forgiven debt, I’d advise enlisting the services of a tax pro. This is complicated stuff, and not an area where you want to get it wrong.

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