Sell a property or lose it in foreclosure, you may end up with phantom income and have taxes to pay taxes on the forgiven debt.
Q: Will mortgage companies report to the government the loss of a foreclosed property so that the person will have to pay taxes as earned income for the following tax year?
A: When a home goes into foreclosure or is sold in a short sale, there is usually a significant difference between the amount that is owed and the amount the lender ultimately collects.
If a lender decides to write-off the amount owed but not collected from the borrower, the borrower would receive a benefit as a result of not having to repay that amount. However, if the borrower agrees to repay the amount unpaid after the foreclosure, then the borrower can and will continue to make payments to the lender until the loan is paid off.
The difference between what is collected from a short sale or foreclosure by the lender is also known as the deficiency. Once the lender writes it off, this deficiency is usually reported to the IRS through a 1099-C Cancellation of Debt form. The homeowner would receive a copy of the 1099 form and would have to report the deficiency to the IRS. The IRS typically treats this deficiency as phantom income, meaning you don’t actually have the cash in your pocket, but the IRS sees you as having received a benefit and will tax the amount as if you did receive that cash.
Through the end of 2012, however, the IRS is not treating the deficiency on the sale of a principal residence as phantom income that must be taxed. The lender can forgive the amount and the IRS will note it but not make it a taxable event. Typically, states are following the federal lead on this, so you wouldn’t owe state tax on the deficiency either.
But this rule only applies on the sale of a principal residence. If you sell a second home, investment property or other real estate and you sell it through a short sale or in foreclosure, you may be in for a rude surprise when you find out you owe the IRS a substantial sum of money.
For more details, check out the “Home Foreclosure and Debt Cancellation” article in the IRS.gov newsroom (http://www.irs.gov/newsroom/article/0,,id=174034,00.html). You may also want to check out Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments and IRS Publication 523, Selling Your Home. And remember, the current law that allows you not to report that forgiven debt as income expires at the end of 2012.