If you complete a deed in lieu of foreclosure or short sale on your property, you may be subject to receipt of a 1099-C from your lender for cancellation of debt.
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $100,000 and default on the loan after paying back $40,000. If the lender is unable to collect the remaining debt from you, or waives its deficiency at judgment, then there is a cancellation of debt of $60,000 which generally is taxable as income to you on your IRS Form 1040.
Cancellation of debt also applies when you are granted a waiver of deficiency, or the amount between the value of the home on the auction date versus what the property ultimately sells for. Although you may pay taxes on this amount, it is typically much more advantageous than paying a huge deficiency to the bank.
What was the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
This Act expired on December 31, 2013 but was renewed in early 2016 to cover 2015 and 2016 up to January 1, 2017.
If the forgiven debt is excluded from income, as in certain circumstances such as insolvency, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return.