Selling real estate in this precarious market can be quite a task in and of itself. When the dust clears, sellers often are left to navigate through a maze of issues, not sure what to expect next. Many sellers have no idea what tax forms to expect from the lender, so they have no way of knowing if they received them.
Two forms in particular, the 1099-A and 1099-C, create much of the confusion for sellers, their lawyers and their financial advisors.
Every time real property is sold or transferred, the IRS must be notified. In a traditional sale of property, the seller will receive a Form 1099-S (Proceeds from Real Estate Transactions) to report the sale of the property to the IRS. This form is used to determine whether there is a gain or loss on the sale of the property. In a short sale or deed in lieu of foreclosure, the seller also receives a 1099-S because the property is sold willingly.
However, in the case of a foreclosure, no 1099-S is issued because the “sale” is involuntary. Instead, the seller will receive a 1099-A (Acquisition or Abandonment of Secured Property) to report the transfer of the property. The 1099-A reports the date of the transfer, the fair market value on the date of the transfer and the balance of principal outstanding on the date of the transfer. Just like the 1099-S, the 1099-A is used to determine whether there is a gain or loss on the sale of the property.
Many sellers mistakenly believe that if their property is sold in a foreclosure auction, they will not have any capital gain. This is not always the case. As a result of the adjustments to cost basis in certain situations, there may be a capital gain on property that is sold in a foreclosure auction. This may cause yet another source of unexpected tax liability that the seller is unable to pay.
Now that short sales have become so common, many sellers understand they may receive a 1099-C (Cancellation of Debt), to report the cancellation of debt resulting from a short sale or deed in lieu of foreclosure. What comes as a surprise to many sellers is that they may receive a 1099-C as a result of foreclosure sale as well. Some sellers believe that if they allow their property to go into foreclosure, they will avoid the tax consequences of the cancellation of debt. However, the tax ramifications are the same for cancellation of debt income, whether it is generated from a short sale, deed in lieu of foreclosure or foreclosure.
At the time the seller/borrower obtained the loan to purchase or refinance the property, the loan proceeds were not included in taxable income because the borrower had an obligation to repay the lender. When that obligation to repay the lender is forgiven or cancelled, the amount that is not required to be repaid is considered income by the IRS. The lender is required to report the amount of the cancelled debt to the borrower and the IRS on Form 1099-C, when the forgiven debt is $600 or greater.
There are certain exclusions that can be used to reduce or eliminate the cancellation of debt income from taxable income. This includes discharge of the debt in bankruptcy, insolvency of the seller before the creditor agreed to forgive or cancel the debt, or, if the seller qualifies, relief pursuant to the Mortgage Forgiveness Debt Relief Act (MFDRA).
To summarize, any sale or transfer of property, whether voluntary or involuntary, must be reported to the IRS. Form 1099-S is used for a traditional sale, short sale or deed in lieu of foreclosure; Form 1099-A is used for a foreclosure. A lender may forgive or cancel debt in any case – where it’s a short sale, deed in lieu of foreclosure, or foreclosure – which will result in the issuance of a 1099-C. In order to properly report these transactions on the tax return, sellers should seek advice from an experienced tax professional.