11 Feb Cancelled debt due to short sale and foreclosure may be taxable
If you received Form 1099c from your lender because of foreclosure, short sale, loan modification or debt settlement, the general rule is it is a reportable income. There are however few exceptions that may apply. The exceptions are Home Affordable Loan Modification Program reduction of debt on principal residence. The other exceptions are Bankruptcy and Insolvency.
Question: My second home has been foreclosed and I received a Form 1099c from the bank. Do I qualify for the Insolvency exception?
Answer: Insolvency means you have more liabilities than asset or property. You need to figure out how much you are insolvent to determine how much you can exclude from income. Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the Fair Market Value of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include almost everything you owe.
Question: How should I report the Insolvency exclusion in my tax return?
Answer: To show that you are excluding canceled debt from income under the insolvency exclusion, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II of Form 982 as explained under Reduction of Tax Attributes, in IRS publication 4681.
Example:
In 2010, Britney’s second house was sold on short sale. She bought the house for $550,000 in 2006 and owed $400,000 on the first mortgage and $50,000 on the second mortgage. The house was sold for $300,000. Britney received Form 1099c from the First Bank for $100,000 as debt cancelled on the first mortgage and another Form 1099c from Second Bank for $50,000 for the second loan that was cancelled. Before the sale Britney was insolvent to the tune of $500,000 because of her divorce settlement with Kevin. In this case, Britney do not have to declare as income the two Forms 1099c she received totaling $150,000 representing cancellation of debt on the sold property. She will file Form 982 and check Item 1b on Part 1. Britney will also have to reduce her tax attributes (basis or property) in the form of capital loss. Britney incurred a capital loss of $250,000 which is the sale price of $300,000 less her cost of $550,000. In her case the reportable loss is $100,000 which is her capital loss of $250,000 less cancellation of debt of $150,000.
Note: This is not a legal advice and you have to discuss your case with your own accountant and attorney.