When the Going Gets Tough on Your Mortgage

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What Are the Tax Consequences of the Short Sale of a House in a Foreclosure or Mortgage Recharacterization?
Question by Sarah of Silver Spring

Answer by JC Leahy, MA Accounting

JC Leahy

When the going gets tough and you can't pay your bills, sometimes you can get a lender to forgive part of what you owe. Sometimes the lender doesn't really forgive you; he just gives up trying to collect the debt. He writes it off as a "bad debt."  You can't squeeze blood from a turnip.

This is what usually happens when you lose your home through foreclosure or any similar short sale. The mortgage balance above what the bank collects from the sale of your home is usually written off -- which is considered a form of "forgiveness".

After you lose your house, it used to be that you were then slammed with a sledge-hammer-of-an income-tax bill next time you filed your annual Federal return. This was because the bank would send you a 1099-C for the amount of the mortgage loan "forgiven." That 1099-C amount would be taxed as ordinary income, just like a salary. Not only did you lose your home, but you got a big kick in pants courtesy of your Congressman and Senator via the Internal Revenue Service.

This madness was ended -- or at least mitigated -- with the passage of Bush-era tax cut entitled the Mortgage Forgiveness Debt Relief Act of 2007. Under this tax-cut law, if the mortgage was used  to buy or improve your principal residence, you don't have to include the "forgiven" amount in your taxable income. That's a big relief!! All you have to do is file a Form 982 with your tax return. Form 982 tells the IRS that although the bank reported a 1099-C under your social security number, it's a mortgage for your principle residence and therefore it is excluded from your taxable income.

However, if you have a mortgage on your principle residence and you used the money for anything other than buying or improving the house, you've still got to pay taxes on the forgiven mortgage debt. Also, if it's a second home or vacation home, you've still got to pay taxes on the forgiven mortgage or second-trust debt.

By the way, if any other debt is "forgiven" -- such as credit cards -- you'll probably get a 1099-C in the mail at the end of the year. The old rule was that this was generally taxable income. The new rule is that this is generally taxable income -- but with some juicy exceptions. That's a Journal article for another day.

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