Understanding debt cancellation and the 1099C

In recent years, the number of foreclosures has skyrocketed and short sales have become an increasingly popular trend. Many consumers have wondered how lenders recover money lost on a mortgage after a discount short sale. These unpaid charges are not a major concern to the lender, but the tax ramifications of a short sale or foreclosure can be devastating to the consumer.

Debt cancellation laws and guidelines require taxes to be paid on foreclosed homes, including short sales, and this tax is often never disclosed until a 1099C form is received. Most homeowners who have experienced foreclosure cannot afford this unexpected and often quite high tax bill. As a result, the number of tax delinquencies is increasing as steadily as the rate of foreclosures.

Understanding the 1099C is vital in real estate investing and there are some key points that every real estate investor should understand.

A non-recourse mortgage means that if the loan defaults, the only action the lender can take is to take possession of the property that was financed. As an investor, it is important to know in advance if the loan you are working with is recourse or non-recourse. You must also determine whether or not the foreclosure is considered judicial and whether the home is eligible for principal residence status. Understanding the terms of the loan can help consumers know what taxes may be due after the process.

There are certain conditions that are exempt from debt liability under the 1099C. If the homeowner suffered bankruptcy at the time of the foreclosure or short sale or if the debt was discharged due to insolvency, the forgiven debt is excluded from the 1099C. Farm debt and non-recourse loans, which include most mortgages, are also exclusions.

It is also important to be aware of current and new laws and policies that may affect foreclosures, short sales, and other mortgage alterations. New legislation recently introduced by Congress will greatly help homeowners facing foreclosure, but there are various regulations that control eligibility for this assistance. The program is restricted to the owners’ primary residence and there are also restrictions regarding property used commercially at any time.

While most mortgages are non-recourse loans, meaning the lender can only repossess ownership of the property and not go after the owner personally, many lenders will still file a 1099C. Non-recourse loans are exempt from the debt cancellation tax, but in most cases, the homeowner must defend their exempt status and notify the bank. Unfortunately, most homeowners are unaware of these exclusions and cannot protect themselves.

As a real estate investor, you will most likely work closely with banks to prevent further action against your clients seeking short sales. It’s also important to remember to discuss 1099C exemptions regarding non-recourse loans with the bank, whenever applicable. Most primary residence mortgages fall into the category of non-judgment, non-recourse loans, so in most cases the only way a lender can satisfy the unpaid debt is through foreclosure and no other measures can be taken. Taking the extra time to discuss these facts with your clients can make a world of difference in their lives.

Investment properties, second homes, and other homes that do not qualify as a primary residence are affected differently by the 1099C. Those will be covered in a separate article.