As a bankruptcy attorney, I meet people every day who are in very unfavorable situations. During recent difficult financial times many people have been faced with foreclosure or short sale of their home.
Some people are actually happy to have the opportunity to get out of a loan/debt that weighs on them. Some people are in predatory loans that have adjusted to monthly payments that are no longer affordable or realistic. Whatever the reason, many of these people face 1 big shock that their real estate agent or broker never tells them about:
Tax consequences!
No one enjoys paying the IRS every year. But it can be even more painful when you get hit by a 1099 from your mortgage company for hundreds of thousands of dollars!!
How did this happen? Simply put: Let’s say your house is sold in a short sale for $500,000.00 but your mortgage is $750,000.00. The mortgage company has taken a $250,000.00 loss on the agreement and can claim the loss to the government at tax time. The lender is needed by tax law to send 1099 to all borrowers in this situation. So, when that debt is pardoned for you, it is viewed as income for the IRS. So now you have to pay income tax on that $250,000.00!!!
How did someone who couldn’t pay their mortgage find a way to pay off such a huge amount of income? Well, usually they can’t. Fortunately the legislature in 2007 realized this and passed the so-called Mortgage Forgiveness and Debt Cancellation Act. This gives the borrower a method of being released from paying the debt as long as it is forgiven between 2007-2012. The form used is called Form 982 and must be attached to your tax return. The form can be downloaded here: Form 982. Just scroll to the bottom of the page and download it as a free PDF.