I have helped many homeowners complete short sale transaction and only a handful of people have every received a 1099-C after closing. Many homeowners think that now they have to pay tax on this forgiven debt amount, this is not always the case.
In 2007 and the government released the Mortgage Forgiveness Debt Relief Act which allows in certain cases the amount not to be classified as taxable income.
According to the IRS, several factors to considered when determining whether you will owe income tax on this forgiven debt, which is also known as phantom income:
- Was the debt greater than $2 million? You may be able to exclude up to $2 million of debt forgiven on your principal residence.
- The limit drops to $1 million for a person who files a separate return. (For a married couple filing separately, each can exclude $1 million.)
- You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.
- To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
- Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
- Proceeds of refinanced debt used for other purposes — such as to pay off credit card debt, to buy a car or fund educational expenses — do not qualify for the exclusion.
- You will need to file Form 982 with your tax return to obtain the benefit.
- Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. However, you might qualify under other provisions of the tax code. IRS Form 982 provides more information.
- If your debt is reduced or eliminated, you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. The form will show the amount of debt forgiven and the fair market value of any property foreclosed. You need to make sure the information on the form is accurate. If the information is inaccurate, you need to contact the lender immediately.
The key to your question is whether the home was your principal residence at the time of the foreclosure or short sale. You should talk to your accountant or other tax professional to determine if the Denver home was your principal residence for purposes of the Debt Forgiveness Act.
If the property can be considered your primary residence, you probably won’t have to pay tax on the forgiven debt. If it is considered a second home, then you will.