After suffering through a foreclosure or short sale, there’s a final kick in the teeth. It comes in the form of a 1099 from your ornery mule of a lender.

For the last few years, with foreclosures in high gear, many homeowners were able to avoid paying tax on the 1099 issued after short sales and foreclosures because of the Mortgage Debt Forgiveness Act. The Mortgage Debt Forgiveness Act says that if a homeowner short sells his primary residence or is foreclosed on his primary residence then no tax is owed. This expires at the end of 2012.

What if they don’t extend this? There a few other ways to go as shown below.

First a little background:  A foreclosure or short sale creates what it is called cancellation of debt income.
Income tax has to be paid on cancellation of debt income. For a short sale, the amount that’s taxable is the difference between the amount owned under the mortgage and the amount actually paid back to the lender. For foreclosures, it’s the difference between the market value of the property and the amount due on the mortgage.

If you owned your home for any 2 of the last 5 years before the foreclosure or short sale, then no tax is due on the 1099 because of the Mortgage Debt Forgiveness Act. If you rented the home out temporarily, you will still qualify as long as you meet the any 2 of the last 5 years test. If the property was never your primary residence, then you can’t use the Mortgage Debt Forgiveness Act and tax will be owed on the 1099.
If the Mortgage Debt Forgiveness Act expires, (or if you had an investment property foreclosed or that was sold short) , there are only two ways to avoid paying tax on the lender’s 1099:

1. Claim Insolvency on form 982.
2. File Bankruptcy before the 1099 is issued.

Insolvency. Insolvency means that your debts exceeded your assets on the day that debt was forgiven. This worksheet explains how to calculate insolvency.  Notice that IRA and 401k accounts ARE included as assets. Overall, this seems like a simple calculation but it’s kind of tricky and anyone hanging their hat on insolvency should discuss it with their accountant well in advance of April 15. The insolvency worksheet should be filled out, form 982 is filed and then because you are insolvent no tax is owed on the 1099.

Bankruptcy. If a bankruptcy is filed before the 1099 is issued, then no tax is owed on the 1099. On your tax return, you file form 982 to show that you filed a chapter 7 or chapter 13 and that wipes out the income tax from the 1099

Foreclosures don’t seem to be slowing down and my bet is that the Mortgage Debt Forgiveness Act will be extended again.