After Foreclosure, Here Comes The IRS

If your house is being foreclosed on, don’t expect the pain to end with the foreclosure.

You still have to deal with the IRS.

The IRS considers canceled debt as income, according to the New York Times:

Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount.

The 1099 shortfall, as it is called, stems from an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy.

The Center for Responsible Lending expects that 20 percent of the home loans made in 2005 and 2006 to people with weak credit, commonly called subprime loans, will end in foreclosure. Because so little money was required as a down payment during the boom, the value of many of these houses may be less than what is owed.

Some people in this predicament are fighting the I.R.S. and winning. Sometimes, lower payments can be negotiated with the I.R.S., tax experts say.

The idea seems counterintuitive, but that doesn’t change it:

“Your home has declined in value and you lose it,” Mr. Eggert said. “Then the I.R.S. says you owe tens of thousands in taxes because you got a windfall when the debt was forgiven.”

One way to fight the tax bill is to prove that the home was worth more than you owed on it when it was taken away. Another way is through bankruptcy. If you’re completely broke, you can also try to prove “insolvency.” If your debts are still greater than all your assets, the IRS might leave you alone.

After Foreclosure, a Big Tax Bill From the I.R.S.[NYT]
(Photo:Michael Stravato)

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  1. Black Bellamy says:

    Isn’t it just wonderful how the IRS can declare anything it wants as income? Anything at all, and it doesn’t need permission and there’s no oversight. And if you want to argue, good luck with the attorney bills, suckers!

  2. CumaeanSibyl says:

    I’m having a really weird reaction in my brain right now. On the one hand, if your debts are forgiven, it’s essentially as if somebody gave you money to pay them off with. On the other hand… this just seems weird.

  3. speedwell (propagandist and secular snarkist) says:

    @CumaeanSibyl: Well, it’s weird because you lost your house. If you got to keep the house because your debt was forgiven, then it would be the same as someone giving you money to pay off the loan. But here you’re losing the house as well as cancelling the mortgage. Of course, you didn’t actually own the property in the first place to the extent that it was mortgaged. So you’re not really losing anything. But you aren’t really gaining anything. The bank gets your house, and you get the loan cancelled. Does the bank have to pay income tax on the house it just gained, or declare a loss on the mortgage it had to cancel?

    Whoa, I’m so dizzy.

  4. ArtDonovansDrunkenLovechild says:

    Here is how the IRS looks at it, plus why they have to do this.

    You buy a house for 200k. 3 years later you refinance to take cash out of your now 250k house (a legit growth rate until recently). You take out 50k to help pay off debt, buy a car, ect. Now 2 more years pass and that debt is back but your house is only now at 260k (in a bad market) and you cant refinance again. You sell short at 220k with an agreement from the lender that they will forgive the shortfall to avoid the foreclosure loss. In the books you have now CLEARED $30,000 of the lenders money.

    They (lender) will call that 30 a loss. If its a loss on one side it has to be a gain on your side (which it is).

    Now is that how it happens most of the time, no. Which is why the IRS will allow you to appeal. But if you are being forgiven a debt, that is money that you are adding to your pocket by official accounting and the feds have a right to persue it.

  5. Trai_Dep says:

    Yet Paris Hilton pays less in taxes that some hard-working guy who lost his house. Those Conservatives are SO compassionate! And fair!!

  6. Observer2121 says:

    I think it sounds unfair because the person lost the house but technically it is definately income. The fact of the matter is the bank gave them X dollars and they paid back less than that. The bank essentially gave them the difference. I have no sympathy for the people who clearly overpaid for their homes, none at all. In fact it is because of these people who bid up the prices of homes that a lot of us young people today can only dream of owning a home. I hope the IRS shows no mercy whatsoever so that they think twice about overspending and creating another bubble ever again. These people were very irresponsible and now everyone has to pay for it, anyone who has sympathy for a person who took out a loan for a home with Zero or very little down is naive. Others were refinancing and removing every dollar of equity they could in their homes, they spent the money on who knows what and we are supposed to feel bad that they can’t afford their mortgage now? I’m not glad about it by any means and it’s unfortuante but I don’t feel any sadness for the people who are now paying for their own bad decisions.

  7. Stoodo says:

    @Oberver2121

    Many of these situations are people just like you that bought at the wrong time. You feel no compassion because you never got in yourself.

  8. ScoobyLover says:

    @Observer2121: I agree with you completely. Housing prices in LA have tripled, while income levels have stayed relatively the same. The only reason housing prices went up is because irresponsible people and lenders got these subprime loans and all of a sudden house prices were “affordable” – but when your mortgage is over 50% of your income, it won’t last long.

    So the banks gave out this money, now there is a meltdown – yet somehow I still lose. Why? Because due to their own damn stupidity they have to tighten credit. So consumers like me end up having to pay for THEIR mistake! So when I screw up my own credit I pay, when they screw up, I pay. This sounds fair….

    In any other market my income level would get me a beautiful house. But where I live I can only dream of owning one.

    I can’t even try and find a “cheap” lot to build on because of the spillover into the construction loan market: ” Stated Income Loans Are Not Performing and The Blame Gam…

  9. Scriptor says:

    For anyone who is facing this situation–a foreclosure or any other kind of forgiven debt–you can avoid paying taxes on the amount that’s forgiven if you are insolvent. I forget the exact rules (look it up at IRS.gov), but basically if you have more debt that you have assets, you’re insolvent. If someone has greater assets than the value of their house then they’re probably out of luck, but for settled credit card debts, etc., it’s important for people to know that they are NOT necessarily stuck with paying taxes on “income” they never had.

  10. IC18 says:

    @Observer2121:

    You cant just lump everyone who is forced into foreclosure as irresponsible, some are just plain stupid for not thinking ahead.

  11. kbarrett says:

    Simple solution …. just declare bankruptcy before foreclosure.

    The lender will go to the federal bankruptcy court, and get their collateral back, the judge will order a sale of the rest of your assets, excluding things you need to get to work and do your work, and you will be done with it.

    No debt to forgive at that point because of the bankruptcy proceeding … the IRS gets to pound sand.

  12. rhombopteryx says:

    @kbarrett: &
    @scriptor:

    It is, except for the “simple” part of it… There’s not much simple about tax law in bankruptcy, because the tax and bankruptcy laws are written in a way that often favors the government over many other types of creditors. (Makes sense, once you think about who wrote the laws.) You can often times end up with outstanding tax debts to Uncle Sam even after you’ve gone through bankruptcy. Similarly, while being “insolvent” might prevent the IRS from collecting, it doesn’t mean that those taxes aren’t still owed, and accruing interest and penalties. “Bankruptcy” and “insolvency” aren’t double secret tax passwords. See your bankruptcy attorney for details, obviously.

  13. Scriptor says:

    To rhombopteryx: Of course you should consult an attorney if you have questions, but being insolvent just doesn’t prevent the IRS from *collecting* taxes on debt that has been forgiven–it means you’re not taxed on that “income” at all. The money does not sit accruing interest or penalties. To read more, download IRS Form 982.

  14. Crazytree says:

    you don’t want to get 1099′ed?

    then pay your bill.

    otherwise treat the forgiven debt as a gift and pay your taxes with a smile.

  15. disavow says:

    Funny how people who lose money on their house could end up paying taxes on it–while under certain conditions, people who make money (up to $500k for married filing jointly) may not be taxed at all….

  16. Observer2121 says:

    @Stoodo:

    If people bought at the wrong time I have no sympathy for them either. There is simply no excuse well maybe if a person got hit by a bus and lost their job or something but I doubt that is the case with most people. The majority of people thought that the prices would keep appreciating and they would be able to sell for a profit like their buddy at the office, it not that then they were amazed by the values put on their home so they refinanced and took out a lot of cash in the process, now I should feel bad cause they can’t afford their new mortgage? A home is the biggest purchase most people will ever make so if they try to tell me that a broker fooled them or whatever I would say that for such a large purchase they should have read every detail of their contract twice before grabbing the cash.

  17. rhombopteryx says:

    @Scriptor:
    Agreed, in some cases being insolvent = not having taxes or penalties on forgiven debt. There’s a good blog article on just that, responding to the NYT article that Meg stalks about above – [www.creditslips.org]

  18. Eomiel says:

    I am one of the people facing this situation, the foreclosure anyway. I bought my house in 1994 and started with an affordable payment. Every year since, my house payment has risen, and I have a fixed rate. It has risen to compensate for an increase in taxes and insurance rates. I started paying about 700 per year for my house insurance and just got notification that it is being increased to 3300 a year. I cannot afford the increase it is going to make to my house payment. (According to insurance company it would cost 300,000 to rebuild my home if anything happened to it, yet my house isnt valued at what I purchased it for (39,800.00) due to neighborhood decline). Now I get to look forward to being foreclosed on because I cannot afford my house payment becasue of insurance increases, how is that fair. And now after reading the article I may have to worry about the IRS as well.