Tax Ramifications of Mortgage Foreclosure or Short Sale of Residence

It has come to my attention that many people are unaware of the fact that their failure to pay the full amount of their mortgage can result in their receipt of taxable income. “Sounds great” you say. “Where’s the cash?” You already received the cash. You got it when you took out the mortgage or refinanced. You weren’t taxed then because you agreed to pay the money back. If you don’t, and the mortgage company doesn’t pursue collection, you will get a 1099 for the amount of cash you got that wasn’t paid back. The same thing can occur on a short sale. If your mortgage is $250,000.00, and the bank has consented to a short sale for $200,000.00 and writes off the balance, you will get a 1099 for $50,000.00. That $50,000.00 will be added to your other taxable income in the year you received it, and you may owe the various taxing authorities taxes on that amount.

Don’t panic!!!

There is, at least until the end of 2012 (it may be extended), a program in place that can erase that tax debt under certain circumstances. The Mortgage Debt Relief Act of 2007, more fully explained in I.R.S. Publication 4681, can result in an avoidance of tax. There are other exceptions, including establishing that you were insolvent at the time the debt was cancelled. So, if you get a 1099 don’t ignore it – consult with your tax professional.

If you are contemplating or participating in a divorce and foreclosure, don’t forget to deal with the issue of that additional debt in any resolution.