Sell a home in a short sale. You may have to pay taxes on the sale even if you lost money and may receive an IRS form 1099c

Q: I formerly financed a property in Denver, Colorado that successfully underwent a short sale last year. I lived in the property from 2005 to 2008 and relocated to take a job in Ohio in 2008.

I recently received a 1099C Form indicating cancellation of debt from the two lenders to the Denver properties. After reading some about the cancellation of debt, I am assuming I am responsible for claiming that cancellation of the lender’s debt as income in my 2011 federal income tax return. Am I correct?

A: The 1099C is a tax form created for tax reporting purposes to evidence a cancellation of a debt by a lender with a borrower. Generally, that cancellation of the debt might be income to a borrower.

If you had a business and borrowed $100,000, the bank would actually give you that money with the expectation that you would repay that money. However, if your circumstances change and you are unable to repay the loan and the lender cancels and forgives the debt, you received the benefit of the money but never repaid it. For that reason, the forgiveness of that debt is reported to the IRS and to the individual with form 1099C.

Just because you received the form does not mean that you owe money to the IRS. Several years ago, the Federal government passed a law (Mortgage Forgiveness Debt Relief Act of 2007) that allowed people to avoid paying tax on forgiven debt under some circumstances.

According to the IRS, there are several factors to consider and that go into determining whether you will owe income tax on this forgiven debt, which is also known as phantom income:

1. Was the debt greater than $2 million? You may be able to exclude up to $2 million of debt forgiven on your principal residence.

2. The limit drops to $1 million for a person that files a separate return. (For a married couple filing separately, each can exclude $1 million.)

3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.

4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.

5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.

6. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt, to buy a car or fund educational expenses – do not qualify for the exclusion.

7. You will need to file Form 982 with your tax return to obtain the benefit.

8. Debt forgiven on second homes, rental property, business property, credit cards or car loans do not qualify for the tax relief provision. But you might qualify under other provisions of the tax code. IRS Form 982 provides more information.

9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. The form will show the amount of debt forgiven and the fair market value of any property foreclosed. You need to make sure the information on the form is accurate. If the information is inaccurate, you need to contact the lender immediately.

The key to your question is whether the home was your principal residence at the time of the foreclosure or short sale. You should talk to your accountant or other tax professional to determine if the Denver home was your principal residence for purposes of the Debt Forgiveness Act.

If the property can be considered your primary residence, you probably won’t have to pay tax on the forgiven debt, but if it is considered a second home, then you will have to pay tax on that phantom income.