Short Sales and Foreclosures have become a way of life. But did you know that a tax liability from that asset could haunt you for years to come. With a average of 3 million foreclosures each year since 2007 according to www.RealtyTrac.com, many previous homeowners think the responsibility ended when they did a short sale or “walked away” and the lender foreclosed. But that isn’t the case. A tax liability, showing up as “income” may come in the mail in the form of a 1099C.
Recently a friend of mine completed a “short sale” in Florida. Her family was relieve to have gotten through the process relatively easy. Her husband had gotten a job transfer and they had held onto the property for 2 years in case the job didn’t work out. It did, however, during that time the property took a serious downturn in value and was underwater by $40,000. Months after completing the sale, I got a phone call for her. She received a 1099C for $45,000 showing that amount as additional income. She is not alone. Many lenders, who seem graceful by accepting a “loss” on a property do have some recourse against the homeowners. First, they could choose to acquire a deficiency judgment. This judgment can be attached to other property in the homeowners name, be used to garnish wages and can stay on a credit report for as long as 20 years. It can also be “sold” to other collection agencies. Second, they can have the homeowners sign a “promissory note” to pay the balance of the difference between the mortgage balance and the actual sale amount. This can also be attached to another property. Finally, the lender can agree to “cancel” the debt owned. But not so fast, it isn’t what you think.
If the lender chooses to “cancel’ the debt, the IRS considers the amount as “income.” This means you will be taxed anywhere from 15% to 30% on that debt. If you live in state that has income tax, you will owe taxes on the amount as well. There are several exceptions this rule:
When the borrower received a bankruptcy discharge, however, the deficiency must be included in the bankruptcy.
If the borrower is insolvent at the time, meaning your liabilities are great than your assets. But you must be able to prove this to the IRS.
When the debt was secured by a non recourse loan. This means the lender cannot come after the homeowner personally. Check your state law, as most residential loans do not fall under this category.
If the property is an investment property and the tax liability can be offset by expenses. This rule does not apply to residential properties.
If the tax liability is not paid to the IRS, be aware that you could start to acquire tax penalties which over time could be very costly.
With the popularity rising in strategic default and such website as www.YouWalkAway.Com, many homeowners see foreclosure as a choice. Sadly, for others, the choice has already been made through job loss, illness or other unforeseen circumstances. Homeowners may be mislead by the thought that once the home is foreclosed upon their liability to the property ends. This is not true. The lender may choose to send a 1099C form to the previous homeowner and also inform the IRS. The liability on this tax can be huge. For example, a property purchased in 2007 for $400,000 goes into foreclosure in 2009. The lender sells the property for $200,000 in 2010. The previous homeowners received a 1099c in the mail for $200,000. Now, the taxes due on this “income” can range from 15% to 30%. This means the homeowner can owe, without taking deductions into consideration, between $30,000 to as much as $60,000! That doesn’t include additional taxes if the homeowner lives in a state that has a state income tax. The tax liability will be due by April 15th 2011. If the liability is not paid, the penalties that accrue can be astronomical.
The reasons stated for the short sale as exceptions above still apply to foreclosures. However, for many people who decided to be a “real estate investor”, multiple foreclosures can create a tax liability well into the six figure range.
For homeowners who receive a 1099c it is best to contact a tax attorney or CPA. They can give advice into current tax laws, and offer possible negotiation with the IRS for a payment plan schedule. Also, if you live in state that have a income tax, your tax professional can offer advice on how these types of situations are handled. Each state has a different rules of tax law. For example, North Carolina, has set up a payment schedule for taxpayers in this situation and has also allowed for these taxes to have a delayed start date. Bankruptcy does not immediately dispatch your IRS liability as the debt has to be seasoned over a period of time.
For many homeowners, it is important to know how a foreclosure or short sale can affect your standing with the IRS, the courts and the type of recourse available to your lender. The more informed you are the less likely you will face a situation that will be unexpected and financially devastating.