Bankruptcy Regarding Foreclosure and Short Sales and Tax Consequences

As a bankruptcy lawyer, every day I come across people who find themselves in very unfortunate situations. During recent difficult financial times, many people have faced foreclosures or short sales of their homes.

Some people are just happy to have the opportunity to get out of a loan/debt that was weighing them down. Some people had a predatory loan that had been adjusted to a monthly payment that was no longer affordable or realistic. Whatever the reason, many of these people were in for a big surprise that their real estate agent or broker never told them:

Tax consequences!

Nobody likes to pay the IRS every year. But it can be even more painful when you receive a 1099 from your mortgage company for hundreds of thousands of dollars!

How did this happen? Bottom line: Let’s say his house sells for a short sale for $500,000.00 but his mortgage was for $750,000.00. The mortgage company has taken a loss of $250,000.00 on that settlement and can claim that loss from the government come tax time. The lenders are required by tax law to send a 1099 to all borrowers in this situation. Therefore, when that debt is forgiven, the IRS treats it as income. So now you have to pay income taxes on that $250,000.00!

How can someone who can’t pay their mortgage find a way to pay income for such large amounts? Well, usually they can’t. Fortunately, the legislature in 2007 realized this and passed what is called the Mortgage Forgiveness and Debt Cancellation Debt Relief Act. This gives borrowers a method to be exempt from paying that debt as long as it was forgiven between 2007 and 2012. The form used is called Modelo 982 and must be attached to your tax return. That form can be downloaded here: Form 982. Just scroll to the bottom of the page and download it as a free PDF.