Although I posted an article on this topic of tax debts after foreclosure on July 12, 2011, this question still comes up fairly frequently.  Therefore, another blog post on it is in order.  However, this one will not be a carbon copy of the July 12 post.

I.          The Five Exceptions To Cancellation Of Debt Income Tax

When a creditor forgives a debt you owe, the forgiven debt is usually credited to you as income for tax purposes.  The typical scenario these days involves the loss of a home in a foreclosure or a short sale.

Due to a provision in California real estate law, if the lender comes up short after the sale, it cannot come after you for the deficiency.  Instead, it will report the loss to the IRS and the Franchise Tax Board (“FTB”).  When it does, it will send you a 1099-C Form, listing the amount of debt it had to cancel.  This is your cancellation of debt income, and it’s taxable unless it falls within five exceptions listed in the Internal Revenue Code, and incorporated into the California Revenue & Taxation Code.

Those five exceptions are:

• the discharge – i.e., the debt forgiveness – occurred in a bankruptcy,

•the discharge occurred when you were insolvent,

•the indebtedness discharged was qualified farm indebtedness,

•in the case of a taxpayer other than a C corporation, the indebtedness discharged was qualified real property business indebtedness, or

•the indebtedness discharged was qualified principal residence indebtedness which was discharged before January 1, 2013.

For the first exception to apply, you have to have filed the bankruptcy before the debt was forgiven.  That way the debt is discharged in the bankruptcy.  If the debt is forgiven before you file the bankruptcy, then at the point of forgiveness the identity of the creditor changes from the bank to the taxing authority, and the debt you have is a tax debt instead of a mortgage debt.  Tax debts are usually not dischargeable in bankruptcy, so you could be out of luck.  (I’ll discuss the dischargeability of income tax debt in bankruptcy in my next post.)

For the second exception to apply you have to still be insolvent immediately after the debt was forgiven.  To illustrate what could go wrong, let’s use an example.  Suppose just before a foreclosure sale on your home your total debt was $525,000 – of which $500,000 was your mortgage debt.  And suppose your assets including the house were worth $450,000, with the house being worth $300,000.  At that point you would certainly be insolvent because the value of your debts ($525,000) exceeds your liabilities ($450,000).  However, insolvency for the second exception is measured after the sale, not before.  Thus, if the house sold for its market value of $300,000, and the bank forgave the post-sale shortfall, then after the sale your assets would be in value $150,000 (= $450,000 – $300,000), and your liabilities would be $25,000 (= $525,000 – $500,000).  This would mean that the value of your assets ($150,000) would be greater than your liabilities ($25,000), so you would no longer be insolvent – and you would be ineligible for the insolvency exception.  Ouch.

The third and fourth exceptions generally do not arise in the typical consumer bankruptcy case.  Therefore, if you think you might be eligible for either of them, consult a competent tax professional.

The final exception sunsets on January 1, 2013, and was enacted in response to the current housing mess.  If you lost your principal residence – this one does not apply to a rental property – and the debt that was forgiven was the original purchase money debt, then the amount forgiven after the sale does not get added to your gross taxable income.  Unfortunately, if you refinanced your home, and later lose the property, the debt forgiven would not qualify for this exception – unless you could prove to the taxing authority’s satisfaction that every penny of the refi went into home improvement.

If the forgiven debt does not fall within the ambit of any of these five exceptions, prepare for a tax hit.

II.        Filing The Tax Return

Suppose you were smart and filed for bankruptcy protection before the debt was forgiven.  Then the debt was discharged in a bankruptcy, so you don’t get the tax hit.  But the taxing authority won’t know that the debt was discharged in bankruptcy.  Contrary to what you see in the highly entertaining Bourne movies, the federal and California governments, and in particular, the IRS and the FTB, are not omniscient.

Therefore, when the taxing authority receives the 1099-C from the (former) creditor, it will assume that the cancelled debt should be credited to you as income.  To obviate this problem you should include the one-page Form 982 with your tax return – both state and federal – and check box 1 a because the debt was discharged in a title 11 case; title 11 of the U.S. Code being the U.S. Bankruptcy Code.

You may wish to consult a tax professional to help you complete your tax returns.

If you’re close to losing a home in foreclosure, or expect to have a creditor forgive a debt you owe, hire an expert los angeles bankruptcy attorney to help you before it’s too late.  Good luck.