The first week of February 2011 will be bleak for those that went through a foreclosure in 2010. That’s because lenders are required to issue form 1099 after a foreclosure and the 1099s are usually received that week.

Some ignore the 1099 and don’t claim it as income and have problems with IRS for years to come. If there’s one piece of advice I can offer to those who were foreclosed in 2010 (and there were many of you)  it’s this: Don’t ignore the 1099. For most, the foreclosure was of their primary residence, and luckily there is an exception for primary residences through 2012 that makes the foreclosure tax free, but that doesn’t mean you can ignore the 1099.

For those who had an investment property foreclosed, or a property that was not their primary residence, it is truly hammer time and all I can suggest is please, please get some good tax advice asap.

Here’s how the whole 1099-after-a-foreclosure thing  works. The lender must issued form 1099-C which is titled “Cancellation of Debt” after the foreclosure. This does not mean the mortgage debt is cancelled. It means that the lender is reporting to IRS that the debt was cancelled. Cancelled debt is taxable. Fortunately, you will not owe income tax on the entire amount of the 1099, just a portion of it.

Here’s how cancellation of debt is calculated:

Step 1: Take the total amount of the debt at the time of the foreclosure. If your mortgage was $200,000 and there was an additional $10,000 in interest and attorneys fees, the total, for example would be $210,000.00.

Step 2. Subtract the fair market value of the property as shown on the 1099C. Usually the lender reports this on the 1099, but if not, you will have to determine the value. Let’s assume the value of the property was $150,000.00

Step 3. The result is $60,000.00 that is taxable to the foreclosed owner in 2010.

Fortunately, there are three ways to completely knock the 1099 out of the tax picture and make it totally nontaxable. That is where form 982 comes in. The 1099 is shown as income on your tax return, but then it is subtracted by filing form 982, so the net effect is no additional tax. Here are the three ways to avoid paying taxes on the 1099 and these are shown on form 982:

1. Taxpayer filed bankruptcy. If a chapter 7 was filed before the 1099 was issued no tax is due. One cannot wait until after the 1099 is issued to file bankruptcy, it is too late then. The case has to be filed before the 1099 comes out.

2. Insolvency. The taxpayer is insolvent, in other words,  the debts exceed the assets. I want to caution that this is not as easy as it sounds and you absolutely, positively have to talk to a tax professional about this well in advance of receiving the 1099.

3. Primary residence. If a primary residence was foreclosed, then no tax is due on the 1099. This exception only runs through 2012. A primary residence is a property used as your primary home for any 2 of the last 5 years.

So those whose primary residences were foreclosed will be fine, but those who had investment properties foreclosed are left with only two remedies: File bankruptcy before the 1099 hits or claim to be insolvent.

The fact that you received a 1099 does not mean that you the lender has given up getting a deficiency judgment against you. In most cases, the lender will not pursue you for a deficiency judgment if a first mortgage was foreclosed and the lender issued the 1099 to you. Technically, the lender could still pursue you for deficiency judgment even after a 1099 was issued, but I am seeing no deficiency judgments for first mortgages here in Illinois.