Foreclosures and Short Sales
Tax Information
It's been two terrible years, so far, and who knows when we will see the end. Many of my clients have lost rental properties to foreclosure, and a very few have lost their homes. And to make things worse, the foreclosure (or short sale) may create taxable income.
You should receive either a Form 1099-A or a Form 1099-C from the bank. (In some cases where the banks have gone out of business, no forms are issued.) The forms should show what the bank estimated the property was worth when it foreclosed or the short sale closed. It should also show the balance of the mortgage. It is important that you check those figures. The bank may have guessed very low regarding the property's value. And it may have included accrued interest in the mortgage balance, which is incorrect.
The difference between the unpaid mortgage and the value of the property is "cancellation of debt" and it's generally taxable income. There is federal tax relief if the property was your primary residence (not a rental) and the mortgage was the original purchase mortgage. If there have been equity withdrawals, there may still be partial tax relief. California has similar relief, but with lower limits.
One positive note is that the loss of a rental property is treated as a sale. So you will report a loss equal to what you paid for the property, minus depreciation, minus the fair market value of the property at the time the bank takes it. Also, if you have unused rental losses from prior years, those are freed up in the year of foreclosure. For many rental property owners, these two items can substantially offset the cancellation of debt income, or even create a net loss.
In addition, your cancellation of debt may not be taxable if, on the day before the bank took the property, your total assets were less than your total debts. This is called the "insolvency exception."
All of the above are just the most common factors to consider, but there are many other exceptions (including bankruptcy) and details not explained here. So if it looks like a foreclosure / short sale is in your future, I strongly recommend that you talk with an experienced tax professional right away.
Bess Kane, CPA
August, 2010
