Foreclosure and Cancellation of Debt

[AccTaxMan]

A foreclosure could result in two source of income to a taxpayer.

(1) Cancellation of debt and
(2) Gain/Loss from foreclosure

Table 1-1 "Worksheet for Foreclosure and Repossessions in Publication" in Publication 4681 is great for the calculation of these two amounts.

http://www.taxact.com/exitdisclaimer.asp?url=http://www.irs.gov/pub/irs-pdf/p4681.pdf

My question is about the ordinary income from the cancellation of debt.

Fact: In this case that I am asking about, the outstanding loan balance is more than the FMV of the property on the date of the foreclosure. Therefore, line 3 in Part 1 "Ordinary income from the cancellation of debt upon foreclosure or repossession" on the worksheet is positive.

My question is: Does the amount on line 3 in Part 1 still have to be reported in the current year tax return even if the debt has not been cancelled?

Or should the taxpayer wait until the later year that he has been informed by the lender that the debt has officially been cancelled and an Form 1099-C has been issued to report the cancellation of debt?

[Gary2]

A foreclosure could result in two source of income to a taxpayer.

(1) Cancellation of debt and
(2) Gain/Loss from foreclosure

Table 1-1 "Worksheet for Foreclosure and Repossessions in Publication" in Publication 4681 is great for the calculation of these two amounts.

http://www.taxact.com/exitdisclaimer.asp?url=http://www.irs.gov/pub/irs-pdf/p4681.pdf

My question is about the ordinary income from the cancellation of debt.

Fact: In this case that I am asking about, the outstanding loan balance is more than the FMV of the property on the date of the foreclosure. Therefore, line 3 in Part 1 "Ordinary income from the cancellation of debt upon foreclosure or repossession" on the worksheet is positive.

My question is: Does the amount on line 3 in Part 1 still have to be reported in the current year tax return even if the debt has not been cancelled?

Or should the taxpayer wait until the later year that he has been informed by the lender that the debt has officially been cancelled and an Form 1099-C has been issued to report the cancellation of debt?

This worksheet is misleading, and you've gotten the wrong answer by not reading it carefully. Line 1 says "Enter the amount of outstanding debt immediately before the transfer of property reduced by any amount for which you remain personally liable immediately after ...." You haven't done that reduction. If you did, then you'd see that line 3 is zero.

But now, let me answer the question a different way: The taxpayer must report the canceled debt income when it's been canceled, whether or not the 1099-C was issued. If you know from other information that the debt has been canceled, you need to report it. You should also nag the lender to issue the 1099-C appropriately.

[S T]

But now, let me answer the question a different way: The taxpayer must report the canceled debt income when it's been canceled, whether or not the 1099-C was issued. If you know from other information that the debt has been canceled, you need to report it. You should also nag the lender to issue the 1099-C appropriately.

Gary - based on your statement above, then how does the reporting work, if we have no IRS reporting documents for the debt cancellation? If we report based on what we might believe we have knowledge on, but the 1099C is issued - say two years after the fact.

Example - we know the debt was canceled in 2012, we know the amount, (report in 2012) but the lender does not issue a 1099C until 2014. (what or how do we handle in 2014)

Nothing will match in the IRS computer system

Sandy

[appelman]

I think it is dangerous to impute debt relief before receiving the 1099-C.

The debt might not be discharged at all! I suspect it is pretty rare for the debtor to know for sure that the debt has been cancelled before the 1099-C has been issued.

[Gary2]

I wasn't suggesting that you casually infer the debt was cancelled. Rather, there must be a concrete reason.

For example, some states have a choice of judicial and non-judicial foreclosure, but only judicial foreclosure allows the pursuit of a deficiency. Thus, if you know that that's the rule for that state, and that there was a non-judicial foreclosure (i.e., not a short sale), then you can conclude reliably that the debt has been canceled.

In MA, it's a bit more complicated. We generally have non-judicial foreclosures, but there's a requirement for additional notice if the creditor wishes to pursue a deficiency. How do you prove that the creditor didn't provide such notice (the old "you can't prove a negative" problem)? I believe that if the debtor can show an actual notice of sale that either omits the required deficiency verbiage or has a date past the deadline (an extra week is required to maintain the right to collect a deficiency), you could proceed safely with the assumption that the debt has been canceled.

The last common case is that a short-sale agreement will often (but not always) include an enforceable condition that the creditor won't pursue any deficiency.

In all these cases, it's worth nagging the lender for the 1099-C. I've only had to do this once, but the 1099-C was issued within a couple of weeks as a result. But from the perspective of a tax professional, if you know that the creditor no longer has any right to collect a deficiency (a legal conclusion that might require a lawyer), then you're required to report the income, even with no 1099-C - just like you're required to report under-the-table income even when there's no 1099-MISC.

[appelman]

I guess I try not to practice law.

The 1099-C is supposed to designate an identifiable event that establishes the amount and date of debt relief. In the case of a foreclosure, it is usually the resale of the property. If the 1099-C comes out with an amount of debt relief for year B, and you have reported a different amount for year A, where does that leave you?

[Gary2]

The 1099-C is supposed to designate an identifiable event that establishes the amount and date of debt relief. In the case of a foreclosure, it is usually the resale of the property. If the 1099-C comes out with an amount of debt relief for year B, and you have reported a different amount for year A, where does that leave you?

It leaves you with two possibilities: you're right and the creditor is wrong, or you were wrong and the creditor was right. Lenders are notorious for being late with the 1099-C, so give yourself some credit for both knowing more and caring more than they do.

What you can't do is act like you have a choice when the information says otherwise. If you know that the lender has lost the legal right to pursue a deficiency, but hasn't issued the 1099-C, you can't omit it from the return. That would be a false return, no different from leaving any other income off the return. The only choice you really have is the amount of effort you put into determining whether or not there was cancellation of debt income.

If there's a chance that the debt may be canceled by act of law, and you don't consider it, you're doing your client a disservice. Suppose the lender's accountants discover that they still have the account on their books four years later, so they write it off and issue the 1099-C (even though they should have written it off at the earlier time). If you didn't report at the foreclosure and decide to report it along with the 1099-C, you've lost the principal residence exclusion (the debt hasn't been secured by the principal residence for four years), and, if the taxpayer has gotten back on their feet, you've lost some or all of the insolvency exclusion.

[S T]

Gary
I do understand what you are saying - and I have an issue with a client now that probably falls into this "criteria"

What I would also be concerned about is the other issue " IRS computer matching" and how we deal with that?

Report in the year of event as we know it and do the right thing - and then the Lender's are not doing the right reporting and issuing the 1099C or 1099A in future years.

I know we can submit all of the documents and try to present on our client's behalf, why, how, etc - but getting through to the "IRS Computer" to understand, or the finally assigned "Worker" is another matter.

Sandy

[Gary2]

Gary
I do understand what you are saying - and I have an issue with a client now that probably falls into this "criteria"

What I would also be concerned about is the other issue " IRS computer matching" and how we deal with that?

Report in the year of event as we know it and do the right thing - and then the Lender's are not doing the right reporting and issuing the 1099C or 1099A in future years.

I know we can submit all of the documents and try to present on our client's behalf, why, how, etc - but getting through to the "IRS Computer" to understand, or the finally assigned "Worker" is another matter.

First, as I said previously, nag for the 1099-C. This has worked for me the one time I had to deal with the issue. In the cases where you know the debt is legally canceled, the lender isn't withholding the 1099-C because they disagree; they're withholding it because the department responsible for issuing them is understaffed. This is a case where being a squeaky wheel can get the grease.

If that doesn't work, it's really no different from any other erroneous information document where the issuer refuses to correct it. The computer will spit it out, and you'll have to respond. The response will include a copy of the return for the year in which the income was reported, a brief statement for why the income was legally canceled that year, and any necessary documentation (such as the foreclosure notice).

Aside: People may be making too much of this. A bigger issue is what happens when the lender issues the 1099-C because one of the identifiable events have been triggered, but they haven't legally canceled the debt and indeed, proceed to try to collect. See this Forbes article on the subject.

Second aside: When a personal debt is discharged in bankruptcy, the lender isn't required to issue a 1099-C. In theory, the bankruptcy trustee will still need to report the canceled debt on the bankruptcy estate's 1041 (along with the 982, since it won't be taxable). But often they don't file it, because there's no other reportable income, in which case some people advise filing the 982 on the next personal return, to document that taxpayer is at least aware of the required tax attribute adjustments.