Irs Tax Attorney - Irs Form 1099-A, 1099-C and the Cancellation of Debt in Foreclosure
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Okay, so misinformation and blurring about the tax implications of foreclosure arising from the cancellation of debt seems to be piling up. In particular, folks seem most confused by the receipt of Form 1099-A from lenders who have taken asset back in foreclosure.
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How is Irs Form 1099-A, 1099-C and the Cancellation of Debt in Foreclosure
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First, remember the basic principle: Cancellation of debt May effect in assessable commonplace income.
Second, because a foreclosure is viewed as a "sale of property," if you let real estate go in foreclosure and it results in a cancellation of debt, then that foreclosure may be a assessable event.
There are three exceptions:
1. First, if the asset lost in foreclosure is a considerable residence-literally the home in which you live-then the cancellation of the debt ("Cod") generally won't be taxable. This is a effect of the Mortgage Forgiveness Debt Relief Act of 2007.
2. Second, if your are "insolvent" at the time that the debt is cancelled (not at the time of the foreclosure, but more on this below) then you will not be taxed. Insolvency is a easy equilibrium sheet test: If your liabilities exceed your assets, you are insolvent. Don't over think it. You will have to submit Irs Form 982 with the tax return in the applicable year in order to demonstrate that insolvency.
3. Third, if the debt is cancelled as a effect of a bankruptcy filing, then there is also no tax. (This is one of the reasons I call bankruptcy "the greatest mortgage modification tool.")
So what about this Form 1099-A business? Form 1099-A is the form that the lender sends you (and the Irs) that documents that the lender has accepted real asset in partial pleasure of a secured debt. It does not originate the tax liability. It is not documentary evidence of cancellation of debt. It is a tax neutral document.
The document that causes the question is the Irs Form 1099-C. This is the one that tells you that the bank has cancelled the debt. It has two effects: First, it can be used as evidence in a later lawsuit by the lender to refute an allegation that the debt is still due and owing. It is not proof; it is just evidence, or as lawyers like to say, it is "probative but not dispositive." Second, it will likely give rise to the possibility of a assessable event absolutely because it constitutes a statement by the lender that the debt has absolutely been cancelled. (The above exceptions still apply, but how you need to deal with the question will change.)
Remember: Foreclosure doesn't per se cancel the debt; it merely satisfies that part of the total debt which is equal to the value of the property.
Here's the down and dirty of it: You are not likely to receive a Form 1099-C from a foreclosing lender on a recourse obligation because they want to hold out the possibility of recovering a insufficiency for as long as they can. (Assuming, of policy that the anti-deficiency laws allow it...But that's a whole distinct topic that I won't get into here.) In California, the statute of limitations for breach of written covenant is four years. (California Code of Civil policy §337) That means that if the lender is not otherwise barred from recovering a insufficiency for one suspect or another-and in California that is an big "if"-then they have up to four years from the time of breach to bring that action. And that, in turn means, that you may not even know either you have tax question from a foreclosure until up to four years after the foreclosure. This is simply because there are only three ways a debt is cancelled: payment by the obligor, voluntary cancellation by the lender or by execution of law. Like because it is time barred.
So since only part of the debt is paid by the foreclosure, and since you've only received a 1099-A, without that 1099-C, the claim stays alive until it dies by some other means. Prudent tax pros generally counsel that it is wise to contribute some sort of estimated liability if the asset has been lost to foreclosure, and you still haven't received her 1099-C. I tend to disagree with that somewhat, because there is no Cod tax until the debt is absolutely cancelled, and the debt isn't cancelled until the lender or the law says it is. Estimating the liability based on an assumption that recourse debt will be cancelled finally may originate a need to amend the return later if the lender comes after you. Of course, if the debt is unambiguously non-recourse, meaning that no insufficiency is possible, then it makes sense to go the evaluation route because the debt is now cancelled by execution of law.
Last, an issue associated to this is the incompatibility in bankruptcy dischargeability status in the middle of a mortgage debt owed to a lender, and an income tax debt owed to the government. They are not treated the same in bankruptcy: If you owe the bank and you file, then the debt is immediately dischargeable. But if you wait until you have filed the tax return and income tax on the Cod (cancellation of debt) is absolutely assessed, then it is no longer as absolutely discharged in bankruptcy. Because back income taxes are not dischargeable until two years after the tax return was last due and ten months (approximately...it's absolutely 280 days) after the tax is "assessed," if you wait to file bankruptcy until after you have filed your tax return, you have converted an immediately dischargeable mortgage insufficiency owed to a bank into a tax debt owed to the government that you will have to live with through that waiting period before you can dump it in bankruptcy. Capiche?
Because these problems involve the interplay in the middle of basic covenant law, mortgage and anti-deficiency laws (all of which are state law issues), and federal tax law, these can be gnarly problems to sort out. Unfortunately, not many attorneys understand them, and not a whole lot of tax pros either. This is because no one's ever lost money on a real estate investment before now. Well, that's not absolutely true of course, but we are seeing things that are changing history, and testing the limits of most general practitioners. If you think you may have a tax question arising from a past or pending foreclosure, make sure you seek professional guidance from person who understands the issues. It will vary from state to state, due to the differences in anti-deficiency legislation.
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Irs Form 1099-A, 1099-C and the Cancellation of Debt in Foreclosure.
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