Avoid the Cancelled Debt and 1099-C Minefield

I speak with many clients in the Tampa Bay, Florida area who have heard of cancelled debt and 1099-C forms but they do not really understand the impact of the taxable events that occur in a short sale. An understanding of how a 1099C works in a short sale is especially important at this time of the year.

Whenever a creditor cancels or forgives debt following a debt settlment, short sale or even a foreclosure, the creditor must report the amount of the cancelled debt to the IRS on a Form 1099-C. Under Section 108 of the IRS Code, the IRS imputes the cancelled debt as additional income to you. So if you make $50,000 in annual salary, but your house was sold at a short sale where the loss to the lender was $100,000 (not an uncommon fact pattern in Florida), you will be deemed to have earned $150,000 that year or the next – depending upon whatever year the lender files the 1099-C.

There are three exceptions to this rule. First, you file bankruptcy prior to the issuance of the 1099-C. If debt is discharged in bankruptcy, it is not attributable to you as income. Even if you receive a 1099-C, you can respond by filing your own Form 982 to remove its taxability because of the bankruptcy.

Second, if the cancelled debt occurs while you are insolvent, you can reduce the amount of the cancelled debt from your income. See U.S.C. Section 108(a)(1)(B). However unlike a bankruptcy, a solvency determination includes all of your assets, including your IRAs and 401ks. In a bankruptcy, your 401k and IRAs are generally exempt from creditors including the IRS. Not so in an insolvency determination.

Third, President Bush provided a major exclusion in the Mortgage Debt Relief Forgiveness Act of 2007 – in effect until December 31, 2012, whereby if you have cancelled debt stemming from a qualified principal residence, then the cancelled debt is not counted as income. It is uncertain if that Act will be extended past December 31, 2012. This would not work for second mortgages incurred to pay credit card debt, nor would it work for investment or second homes.

While bankruptcy is not always the best option, it is important to understand the law before negotiating with your creditors. Otherwise you may avoid one minefield, only to step into another.