There is an unpleasant aftershock from a foreclosure or short sale.
A client received the 1099 below last week after the foreclosure of his home. Lenders will issue a 1099 to the borrower after foreclosure and, surprise, the client will owe income tax on the amount in the 1099. The client was quite distressed to get this in the mail.
The 1099 means that he has $189,385.26 more in taxable income for 2009. That is because when a mortgage is foreclosed, it is deemed to be “forgiveness of debt” and it is counted as income to the borrower, due to the fact that the borrower does not have to repay the mortgage.
Fortunately, since this was the client’s primary residence and, while he must report the 1099 on his taxes, he can exclude the 1099 from his income. Form 982 is used to exclude the 1099 from income. This was the client’s primary residence and there is an exclusion for primary residences only (no vacation homes or investment properties get this benefit). Had this not been his primary residences (for any 2 of the last 5 years) he would have owed about $60,000.00 in income taxes, which, of course, was money he did not have.
It is always a good idea for a borrower in financial trouble to try to sell the property at a “short sale” before going through foreclosure. Why? First, in a short sale you can at least pay back some of the mortgage and the amount reported on the 1099 issued after closing by the lender will be less than in a foreclosure. After a foreclosure, the entire amount of the mortgage is 1099’d to the borrower.
As I wrote recently, after a short sale or foreclosure, a lender is required to issue a 1099 for the amount that was not repaid. The lender can also pursue a deficiency judgment against the borrower. In Illinois, most lenders on first mortgages are simply issuing 1099s after foreclosures and short sales. They are not seeking deficiency judgments, although they could do so. Technically, the lender can do both of these: a.) 1099 the borrower and b.) seek a deficiency judgment, but that rarely happens. In practice, most lenders just issue 1099s and don’t pursue deficiency judgments. However, borrowers have to be aware that the issuance of a 1099 does not cut off liability for signing the note.
Second mortgages are another story and many of those are being turned over to collection agencies, rather than the lender seeking a deficiency judgment.
Many clients are not aware of the 1099 issue. So the best route if you are in financial trouble with real estate is:
- File for a loan modification first (although it’s easier to get hit by lightning than to get this approved). The only reason to do this is the new short sale rules that start soon require a loan modification first, before a short sale.
- List the house for sale and try to get the lender to approve short sale.
- Ask the lender in the short sale for a “no deficiency” payoff, especially if the property is an investment property.
- Beware that a 1099 will be issued after a short sale or foreclosure and file form 982 to exclude the 1099 from your income.
- At the worst, if the property was not your primary residence, you will have to file for bankruptcy to get rid of the income from the 1099 after the short sale or foreclosure. However, as this excellent post points out, the bankruptcy has to be filed before the 1099 is issued, not after. A bankruptcy filing after the 1099 is issued will not discharge the 1099 income.