1099 Issued by foreclosing lender

[ForeclosureLady]

I had a bank (lender) servicing company explain to me today, that when a property is foreclosed on and the lender get's the property back as an (REO - Real Estate Owned property) that the lender will issue a 1099 for the full amount (owed at that time) to the IRS as Forgiven Debt, and the foreclosed upon buyer will be responsible for taxes on that full amount as if it were ordinary income come the following tax year.

I was under the impression that because the lender received the property back, that when they subsequently sold it at a loss via the REO process, that it wasn't until then that actual forgiven debt amount would be calculated.

This rep also said that it happens this way, everyday, all day long.

Can anyone advise how I can comfirm how this process actually works?

I keep hearing about an 'insolvency exemption' - but I'm not sure how it works, if it works, and whether or not there are any specific rules about how it works.

Advice?

[jainen]

Foreclosure laws vary

>>it wasn't until then that actual forgiven debt amount<<

Foreclosure laws vary from state to state. In a judicial foreclosure against a true mortgage, the borrower remains personally liable for the debt. The lender will try to recover some by selling the property, and may (but does not have to) forgive or abandon the rest at a later date.

In a foreclosure against a deed of trust, the property is the complete security and the borrower has no further obligation. Therefore the debt forgiveness can be determined immediately--it is the full balance that was due. If a later sale recovers some of the money, that is a different issue.

Some states (like California) use both a mortgage and a deed of trust at the same time, and the lender can choose whichever is easiest. That is usually the deed of trust because they don't have to go to court.

[erchess]

Insolvency Exemption

Can someone explain to OP and to me how the insolvency exemption works? I know that if immediately before the debt was forgiven the debtor had debts exceeding assets then the forgiven debt is not taxable. I also understand that there are other situations in which forgiven debt is not taxable. What I would like to know is what forms the preparer uses to claim these exemptions.

[George Boutwell]

Forgive us our (insolvent) debts

Some states (like California) use both a mortgage and a deed of trust at the same time, and the lender can choose whichever is easiest. That is usually the deed of trust because they don't have to go to court.

It's not that it's easier. It's that if the lender chooses a judgment, rather than taking the property back, the judgment can be discharged in a bankruptcy.

The two rules to follow on these 1099-A and 1099-C cases are (1) read the IRS instructions for preparers of those forms; and (2) assume that the lender is reporting the transaction incorrectly, because that is often the case.

Cancellation of indebtedness, although reported, is not taxable if before and after the debt is cancelled the taxpayer is insolvent. "Insolvent" means "liabilities exceed assets." For example, I owe you $5,000; my assets are worth $10,000, and my debts (including what I owe you) are $20,000. My liabilities exceed my assets both before and after you write off the debt, so I pay no tax. On the other hand, if my assets equal $10,000 and my debts (including the $5,000 I owe you) are also $10,000, then the cancellation of indebtedness is taxable because I am solvent, to the full amount of the debt, after it is canceled. Also, you are stupid for not trying to collect it, since I have assets (although maybe they are exempt from collection remedies, so you decided not to bother).

If after you write off the $5,000 I owe you, I am solvent only to the amount of $2,000, then that $2,000 is taxable to me.

From what I have observed, more than 95% of canceled debt is nontaxable, either because of the insolvency exception or the bankruptcy exception (the debt was discharged in a bankruptcy case). If IRS were taxpayer friendly, it would develop a better way of reporting which canceled debts are taxable and which are not. So what do you think they have done? Right. Maybe when Nina Olson finishes traipsing around the country telling us all what a wonderful job the Taxpayer Advocates are doing, she will get around to suggesting that the reporting procedures be improved.

[Oxtrainer]

Insolvent

This 80 year old lady with a Total income of Social Security of about $600 came into
the office with her daughter. She had a letter from the IRS and her Social Security
was threatened. Seems she had co-signed for a son and that son had defaulted and
the Old lady had a 1099 for about 40000. We called the IRS and it seemed very
much like she was stuck and it was a pathetic thing. After talking with the agent and
about to conclude the call the agen said. (Tell me what was her finacial condition
at the time?) Well, it was determined she was indeed insolvent and that agent wrote
it off. Needless to say there was tears of joy and the situation was ended.
Insolvency was something I knew nothing about and it was the IRS agent who brought
it up.

[George Boutwell]

Insolvency is Irrelevant

Seems she had co-signed for a son and that son had defaulted and the Old lady had a 1099 for about 40000.

As I was saying, the first step is to read the IRS instructions for filers of Form 1099-C:

>>You are not required to report on Form 1099-C the following: . . .

Guarantor or surety. You are not required to file Form 1099-C for a guarantor or surety. A guarantor is not a debtor for purposes of filing Form 1099-C even if demand for payment is made to the guarantor. <<

The reason that the canceled debt might be taxable to the son is that he received some economic benefit from not having to pay back the money he borrowed. The reason that it would not be taxable to his guarantor or surety (co-signer) is that she did not get the cash.

[ForeclosureLady]

can get even more complicated

In the case in front of me - there are 2 loans on the property, but only the 1st Lien is foreclosing. It's in a Trust Deed state, CA, and the 2nd loan - may or may not be considered a recourse loan.

In CA many borrowers buying homes secured 100% financing with 2 loans, typically an 80/20. While the first loan would be considered Purchase Money, and therefore a 'non-recourse' loan if the lender were to forelosure using non-judicial foreclosure process, they would supposedly not be entitled to persue a deficiency judgment against the borrower.

As stated above, their only recourse is to reclaim the property.

But, per my call to the IRS yesterday, it is indeed true that the lender can and does send a 1099 for the full amount the borrower owed the lender at the time of foreclosure.

So, now my question is: What happens to the debt that does not get foreclosed upon, but is rather 'wiped out' through the foreclosure process?

If the 2nd loan is a HELOC and/or otherwise considered a 'recourse' loan - is the borrower subject to both a 1099 for forgiven debt and a collection judgment for the debt no longer secured by property - but still personally a liability?

If the 2nd loan is a non-recourse loan - does the second lender get to report a 1099?

[George Boutwell]

>>it is indeed true that the lender can and does send a 1099 for the full amount the borrower owed the lender at the time of foreclosure.<<

That's a 1099-A, not a 1099-C. If the borrower owes $400,000 first mortgage on a $500,000 house, and the lender forecloses, the borrower is considered to have "sold" the house back to the bank for $400,000. If the bank then sells the house for $450,000, there is no debt canceled, because it was paid in full from the bank's sale.

>>So, now my question is: What happens to the debt that does not get foreclosed upon, but is rather 'wiped out' through the foreclosure process?<<

It would be "wiped out" if the second-mortgage holder decides to walk away from the loan. In that case, they issue a 1099-C when the debt becomes uncollectible. Depending on state law, they may still be able to collect the loan even if it is no longer secured by the house. In the example above, they would receive the $50,000 surplus funds from the sale by the first-mortgage bank, so the canceled debt would be only the remaining $50,000. Or, they could pay off the first mortgage (the second mortgage gives them the option to do this) and then add that amount to their debt -- so potentially the amount reported on the 1099-C from the second-mortgage lender could be the entire $500,000 owed on the property, minus the proceeds from its sale by the second-mortgage lender.

>>If the 2nd loan is a HELOC and/or otherwise considered a 'recourse' loan - is the borrower subject to both a 1099 for forgiven debt and a collection judgment for the debt no longer secured by property - but still personally a liability?<<

If the lender is still trying to collect the judgment, there is no debt forgiven.

>If the 2nd loan is a non-recourse loan - does the second lender get to report a 1099?<

It's not that they "get to," it's that they must. What the taxpayer does with it is like adult diapers; it Depends. IRS has an FAQ page that you might find helpful.

http://www.irs.gov/faqs/faq4-4.html

[ForeclosureLady]

what the bank sells the house for later - doesn't affect borrower?

>That's a 1099-A, not a 1099-C. If the borrower owes $400,000 first mortgage on a $500,000 house, and the lender forecloses, the borrower is considered to have "sold" the house back to the bank for $400,000. If the bank then sells the house for $450,000, there is no debt canceled, because it was paid in full from the bank's sale.<

But the IRS guy said a 1099 for the full amount owed would be issued for the borrower.

He also said that the lender would put down a 'fair market value' on the 1099A, and that from the borrowers point of view what the lender later actually sold the property for and the subsequent difference between total amount owed vs total amount received wouldn't matter.

Has anyone seen one of these 1099A's with the 'fair market value' listed? Does it reduce the taxable income (amount owed - fair market value) - or does the full amount owed show as taxable?

Also - what happens in the above example if the house is sold for "Less" than the amount owed at the time of the foreclosure?

[WhiteOleander]

The 1099A is issued when the mortgage is foreclosed. The FMV is used as the sales price. This sale is reported as any other sale depending on the type and use of the property.

The T/P figures their basis in the property to see if there is a gain or loss on the sale. If it is personal use property, report the sale on Sch D. If there is a loss, do not take it. That is not allowed. If there is a gain, report that on Sch D.

If the property was a residence and they otherwise meet the reqirements and choose to, they can exclude the gain under Sec 121.

If the property was investment or business property, it will most likely be reported on 4797 and flow to the Sch D. Follow the same steps as if the T/P had sold the property themself.

When the property is foreclose on, the T/P does not know if any debt has been forgiven. Each state has different rules regarding cancellation of debt. If they do receive a !099C, you deal with that separately from the 1099A.

If on the date the debt was cancelled (this will be different from the date of foreclosure) the T/P was in bankruptcy or insolvent, the debt can be excluded from income. Otherwise, the T/P will have to include it into income.

The 1099A and !099C are two different events and may happen in two different tax years.

HTH