The Mortgage Debt Relief Act of 2007 was set to expire on December 31 2012; however, it was extended for another year, which is a pretty big deal for people who are facing a foreclosure, short-sale or a deed-in-lieu (of foreclosure). Foregoing other reasons why I think the last 2 options, respectively, are not a great for most people, let’s examine why this is still great for people who are facing the tough circumstances of losing their homes.

Let’s first talk about this Debt Cancellation or Phantom Income and how this would normally be treated. To add insult to injury when a person has debt that he/she cannot pay, sometimes what will happen is that the lender will agree to “cancel” this debt and deem it not-collectible, but then will issue a form 1099-C to the unsuspecting debtor that will make this broke debtor liable for income taxes.

(Note, that this is different from a simple debt write-off, which is an accounting term and merits a different discussion, but let’s just say that the write-off the debt for purpose of bookkeeping, but can still try to attempt to collect this debt. This is usually done with 1099-A.)

When a lender issues a 1099-C form, they are no longer allowed to continue collecting and it is usually a result of a negotiated cancellation of debt.

What in the heck do you mean I’ll be responsible for income when I just lost my house? I certainly made no money off this transaction?

You are absolutely right and it sucks, but that’s not how the IRS will see it.

In a short-sale, you have found a buyer who is willing to pay less than what you owe your lender(s) and if the lender(s) agree to this sale for less money, you will not be liable for the remaining amount of the loan. Example: your house is sold to the new buyer for $300k. You owe the lender $400k. The lender agrees to the sale and agrees not to go after you for the remainder of the balance ($100k). You later get a 1099-C form with $100k indicated as income to you. That’s what I call “Phantom Income.” While you didn’t make any money off this transaction, because $100k was “forgiven,” it is deemed income as far as IRS is concerned. However, because the law has been extended, you will now not have to pay any additional taxes.

So I don’t have to do anything with this 1099-C form issued by the bank, right?

Wrong. You still have to file a Form-982, basically explaining to the IRS why this shouldn’t add to your tax liability. You should contact a qualified CPA to help you complete the tax form properly.
Here is a link to the form: http://www.irs.gov/pub/irs-pdf/f982.pdf.
While the form is not too complicated, it is important to get it right and unless you feel super confident, I would hire someone who can help you do it.

Are there exceptions to this law?

Yes, you may still be liable for debt-forgiveness if the property was an investment property or if the mortgage forgiven exceeds $2,000,000 or $1,000,000 for married couples filing separately.

Note, while this Act only deals with debt forgiveness related to mortgages (debt secured by real property), there is similar phantom income that results when someone settles other debts (credit card, medical, etc.) for less than they owe outside of bankruptcy. However, there is no similar law that applies. One can still use Form 982, however, in that situation to avoid having to pay extra taxes for this “income” the person will have to show that he/she were insolvent at the time of this settlement.

If debts are Discharged in Bankruptcy there is no Phantom Income.

However, if debts are excused in bankruptcy, there will be no phantom income, therefore people who are using bankruptcy instead of a short-sale, deed in lieu, foreclosure or debt settlement to settle their debts, will not have to worry about being liable for this phantom income and additional taxes they weren’t expecting. Sometimes, the lenders will erroneously send Form 1099-C anyway, and in those cases, debtors that went through bankruptcy can just mark 1a on Form 982 and attach it to their returns and that’s it.

See my previous post: http://goreliklaw.com/the-magic-of-form-982-and-cancellation-of-debt-income
Note, however, that someone who chooses to do a short-sale or a deed-in-lieu when this law is no longer applicable, and then files for bankruptcy, the bankruptcy filing after the phantom income was incurred will not protect the person (absent an applicable law, or if this is income for an investment property), therefore tax implication should be considered prior to proceeding with this type of transaction instead of bankruptcy.

While, there still may be an insolvency exception to the transaction outside of bankruptcy, note that to show insolvency to the IRS you will have to count your retirement accounts towards the calculations and as such may not be able to qualify.

Final words of advice, from the above lengthy explanation, you have learned that there is a lot to consider and a competent attorney and/or CPA should be contacted prior to making decisions that could have large tax costs. Feel free to contact my office at (310) 481-5098 to discuss your case.