Do you think that once the bank has foreclosed on your home that your financial woes are over? Well, not necessarily so. You could owe taxes on the amount 'forgiven' on your loan. More and more homeowners who have their homes foreclosed due to the housing crisis, especially those who used creative financing, could find themselves facing a rather large tax bill.
I recently experienced this with a potential home buyer who was referred to me by a real estate agent. During the loan application process they disclosed that they had had a foreclosure and were ready to purchase a new home. When I pulled their credit, we discovered that they had some discrepancies with their mortgage account that was paid off, or so they thought when they lost their home. As I further investigated their credit report, I found a $33,000 tax lien that was recently filed against them. They said that they were disputing the lien with the IRS as they had lost their home and thought they weren't responsible for anything more with the home. I did tell them that I wasn't a tax consultant; but that I thought they had gotten this tax lien from the difference in what their house was sold for, and what they owed on it. At this point in time, these folks are setting up a payment plan with the IRS and will need to wait for at least 6 months, probably 12, until they'd be able to qualify for another mortgage.
'You can walk away from the big house payment, but not from the potential tax implications,' says John W. Roth, senior tax analyst at CCH in Riverwoods, Il. 'And if you couldn't afford the mortgage, you probably can't afford the taxes.'
Taxes can be assessed on what is called Cancellation of Debt income (COD). This can occur when either the bank forecloses or you negotiate for a short sale. A short sale is when the bank agrees to let you sell your home for less than what is owed. A short sale keeps a foreclosure from showing up in your credit report, but the shortfall will appear as a delinquent loan. In both cases if you owe more than what the lender receives as repayment of the loan, the difference is a cancellation of debt that is considered taxable as ordinary income by the IRS. They can and probably will issue a 1099 to you for the amount that they "credit" you in the short sale.
So, what happens when you cannot pay Uncle Sam? Well at the very minimum Uncle Sam charges interest and of course there are penalties. The hole gets deeper. There is however, a possible way out of part or all of the tax liability by filing form 982. Form 982 requires proof that you are insolvent and you must provide all documentation to that effect. What has to happen is you show that your liabilities exceed your assets/income. As an example, you show liabilities equaling $40,000 and you receive a 1099 for the cancellation of debt for $60,000, your taxable income will be reduced to $20,000 ($60,000 - $40,000). The downside to filing a form 982 is it's a red flag for an audit so, you'd better be sure you can withstand an IRS audit. If the IRS finds any questionable information they may go back to prior years as well.
Whatever your situation it is best to consult with your accountant before you 'throw in the towel' and send the keys to your lender. You want to be sure of what your tax consequences are before you make your move!
'The best advice is, don't buy a house you can't afford, and make sure you understand the terms of your mortgage.' For professional assistance with home loans it's best to consult with a skilled professional that has your best interests at heart!
Article by Donna Gamaly, Sr. Loan Consultant. Donna can be reached at 602-518-7633. This Article is designed to be of general interest and should not be considered legal advice. The specific information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.
