If you receive a Form 1099-C reporting ‘debt cancellation’ income after a home foreclosure, you may qualify for the Mortgage Forgiveness exclusion. As if the distress of home foreclosure isn’t enough, homeowners may receive a Form 1099-C from their former mortgage lender reporting the deficiency owed as income to the homeowner. The income reported on the Form 1099-C is what’s referred to as “Cancellation of Debt Income” or “Discharge of Indebtedness Income”, both of which generally must be reported as taxable income on an individual’s Form 1040 federal and state tax returns. When the 1099 relates to foreclosed real estate, the amount of cancelled debt can be significant and can consequently result in a substantial increase in tax liability for that year, loss of tax refunds or even additional tax liabilities owed to the IRS and Minnesota Department of Revenue.
For a more detailed discussion on tax debt and other tax resolution issues, be sure to read Wartchow Law’s Tax Blog.
Typically, cancellation of debt is an income realization event that must be reported on one’s tax returns. The idea is that any amount of principal or interest that a person legally owes but does not have to repay is considered taxable income in the year that such debt is cancelled. As an illustration, if you owe a commercial lender $15,000 between interest and principal due on a loan but that creditor agrees to accept $5,000 and cancel the other $10,000 in satisfaction of the full amount, that creditor is required by federal law to issue an IRS Form 1099-C, which reports the $10,000 cancelled debt as taxable income to you. Depending on the circumstances, the amount reported on Form 1099 must be included as personal income unless a statutory exclusion applies. Most of the IRS’s income exclusions are conditioned upon insolvency of the taxpayer—i.e., total debts exceed total fair market value of all assets—however bankruptcy is not necessarily required to qualify under certain IRS insolvency exclusions. Even in the absence of insolvency, a homeowner may still qualify for the Mortgage Forgiveness exclusion.
The Mortgage Forgiveness exclusion is provided under the Mortgage Debt Relief Act of 2007, which allows most taxpayers to exclude 1099 income resulting from the discharge of debt on their principal residence. The key to qualifying for this exclusion is that the debt must have been incurred to buy, build or substantially improve your principal residence and the debt must have been secured by your principal residence. Most traditional mortgages on homestead properties would meet this criteria. Currently, the Mortgage Debt Relief Act only applies through 2012, after which it may be extended by additional act of Congress.
When an individual files for bankruptcy, Section 108 of the Internal Revenue Code automatically excludes any debt that was discharged in the bankruptcy from taxable income. This is why consumer debtors who receive a discharge in a Chapter 7 or Chapter 13 bankruptcy proceeding rarely receive a 1099 regarding any of the discharged debts (and if you do, you should talk to your tax preparer about your options to dispute the 1099).
Wartchow Law Office is a law firm located in Edina, Minnesota with an exclusive practice in Chapter 7, Chapter 13 and Chapter 11 bankruptcy law, representing individual consumer and business clients throughout the Twin Cities of Minneapolis and St. Paul, Minnesota.
For more information on The Mortgage Forgiveness Debt Relief Act and Debt Cancellation, see IRS Publication 4681 and IRS Form 982 available on the IRS website at www.irs.gov. You should always ask your tax professional for tax advice and not rely on information found online. This information is intended for entertainment purposes only and use of any information from this site or any other web site referred to is for general information only and does not represent personal tax advice either express or implied. You are encouraged to seek professional tax advice for personal income tax questions and assistance.