Foreclosure? Short sale? You might owe more taxes than you think

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PHOENIX – It’s the time of year most people dread – tax time. If you’re one of the many who had a foreclosure or a short sale in 2010, you might be in for an unpleasant surprise.

Attorney Stephanie Fierro explained to Tara Hitchcock that people might owe significantly more in taxes than they might think. It has to do with the value of the home involved in that foreclosure or short sale.

“When you short sale or when your home is foreclosed, then whatever debt is forgiven as a result of that counts as taxable income,” Fierro said. “Whenever you receive something other than a W-2, like a 1099 for miscellaneous income, you may receive a 1099 [specifically a 1099-A or a 1099-C] for the debt that was forgiven.”

Fierro said many people are not aware of that, possibly because of the timing.

“It’s not necessarily immediate,” she said. “They don’t have to report it to the IRS right away. But the bank will need to eventually report it to the IRS, so if you don’t, they’re going to, and that can create a big problem.”

Fierro said this applies to both foreclosures and short sales.

“A lot of people are in that position right now,” she said.

While forgiven debt will normally be considered taxable income, there are some exemptions. One of them involves discharging debt in a bankruptcy proceeding. Insolvency – you’re not filing bankruptcy but your total debts outweigh your total assets -- could also be an exception.

Another consideration is whether the loan is a recourse loan, in which the borrower is personally responsible for the debt, or a non-recourse loan, in which the lender cannot go after the borrower for repayment. In a non-recourse loan, once the lender repossesses the property used to secure the loan, the loan is considered satisfied.

Through the Mortgage Debt Relief Act of 2007, there is also an exemption when a primary residence is involved, but Fierro said it’s not going to apply in every case.

A 1099-A is issued when a borrower abandons a property. According to instructions for the form, "An abandonment occurs when the objective facts and circumstances indicate that the borrower intended to and has permanently discarded the property from use."

A lender issues a 1099-C when it forgives a debt for $600 or more. The amount on a 1099-C as taxable income.

Depending on your individual circumstances, Fierro said it’s a good idea to consult with both a tax professional and an attorney.