Lessons in Foreclosure: The Aftermath of a 1099-C

     Originally published in the NV and CA Examiner 10/29/2010 issue

     While we are witnesses to the millions of homes that were foreclosed in the past two years all across the country, we anticipate that there will still be millions that will be foreclosed in the near future. Even if there was temporary halt of foreclosures about two weeks ago, as Attorneys  general from all 50 states launched a joint investigation into allegations that mortgage-servicing companies submitted fraudulent documents and broke laws in foreclosure proceedings, the freeze has now thawed and foreclosures will now proceed as planned or scheduled.  For some observers, they say that a Foreclosure Moratorium is actually a bad idea. For starters, it will not address the underlying issue that thousands of homeowners can’t make their mortgage payments. According to Barbara Novick, Vice-Chairman of Black Rock Investment Management, “postponing the resolution of these debts will actually prevent consumers from extricating themselves from loans they can’t afford. Worse, a national foreclosure moratorium will exacerbate the housing-market crisis and prevent supply and demand from ever reaching its equilibrium.”

      Indeed, the topic of foreclosure, whether in the investment world or the tax world, is still very hot and does qualify to be referred to as the “talk of the town.” In my book, it will do well for all tax practitioners to equip and arm themselves with this knowledge so that they are able understand it themselves and eloquently relay it to their clientele. Las Vegas, and maybe some parts of California, could be a place or two, where probably two out of every five homeowners had been or is going through foreclosure. The stats from my readings reveal that almost half of all homeowners all around the country where they are “upside down” or “underwater” in their mortgages are all candidates for foreclosures.

     So let’s get some eye-openers here as we learn some lessons in foreclosures. But before I discuss the implications of foreclosures, let me give you a bird’s eye view of what foreclosure can mean to an individual who has not yet consulted an Enrolled Agent or a licensed tax professional in this issue.

     Foreclosure is one of the most negative, if not the most negative, items in our credit report. They say it can affect one’s credit score by more than 300 points. A foreclosure will remain on our credit report for as long as ten years and is permanent in the public records of the county in which the property is located. Present and future employment can also be affected by foreclosure since employers have the right to check one’s credit, especially those who are in very sensitive job positions.

     So when does foreclosure begin and when does it end? Well, normally a foreclosure begins its process when the homeowner decides to stop making payment on his or her mortgage. Surely there are valid reasons from the side of the homeowner, such as decrease in income due to unemployment or business failures, etc., why they have decided to stop making payments. However, in a depressed housing market, such as what we have right now, one reason stands out: The property has lost its value.

     After the homeowner had been bombarded with letters of default, the mortgage company will soon foreclose on the property. And after the foreclosure proceedings, the homeowners try to piece their lives together or whatever is left of it. The fact is, majority of them don’t really know what lies ahead of them.

     A few months later after they have settled in some blighted and unwanted apartment dwellings or moved to their in-laws, the homeowner or now the new ex-homeowner receives in the mail a 1099-C (Cancellation of Debt) from the Mortgage Company. So what will she or he do now?

     The ex-homeowner should consult with an Enrolled Agent or a licensed Tax Professional such as a CPA or Tax Attorney, and pretty much the consultation will have a semblance of the following explanation:

(1)   A foreclosure is treated as a sale that may result in a gain or loss. If the outstanding loan balance is greater than the fair market value of the home and the lender cancels all or part remaining loan balance then one will realize ordinary income from the cancellation of debt. This amount should be reported as income on the tax returns, unless exceptions apply.

(2)   A qualified principal residence indebtedness exclusion is available if the mortgage taken out is to purchase, build or substantially improve a home. This loan must be secured by the main home of the borrower. Qualified principal residence indebtedness also includes any debt secured by the main home that is used to refinance a mortgage taken out to buy, build or substantially improve a main home, but only up to the amount of the old mortgage principal just before the refinancing.

(3)   This exclusion is provided by the Mortgage Forgiveness Debt Relief Act of 2007. This act generally allows taxpayers to exclude from income discharges of debt on their principal residence. Debt reduced through restructuring as well as mortgage debt forgiven in connection with this foreclosure qualifies for the relief. This debt relief applies to debt forgiven in years 2007-2012. Up to $2 million of forgiven debt is eligible for exclusion ($1 million for married filing separately). This exclusion does not apply if the discharge is for any other than a decline in the home’s value or the taxpayer’s financial condition.

     In conclusion, when a lender has written off or cancelled debt, as in a foreclosure, it will result in a 1099 C being issued to the borrower. The IRS views this as an income. But if handled correctly by an Enrolled Agent, who is licensed to practice before the IRS, or another licensed tax professional as a CPA or lawyer, he or she can totally eliminate any taxable consequence of these situations.