As foreclosures soar, a cruel tax rule rears its head. By Kevin McCormally, Chief Content Officer June 13, 2007 At first blush, the double whammy seems so cruelly unfair that it must be untrue.First, you lose your house in a foreclosure -- perhaps you fell behind in the payments after you lost your job, you got sick or your husband or wife died. Then the law orders the IRS to pile on the grief by charging you income tax on part of your loss. Outlandish, perhaps. But, as tens of thousands of homeowners will soon learn, it's also true. If the bank sells your home for less than the amount left on your mortgage, any forgiven debt can be treated as taxable income. The IRS even has a special form for reporting this windfall: the 1099-C. The C stands for cancellation of debt and the law says cancelled debt is taxable just the same way salary is. (There are exceptions, which we'll get into later.) This issue is becoming more important as a wave of foreclosures sweeps the nation, fueled by the risky loans, rising rates and a slowing housing market. RealtyTrac.com, an online marketplace for foreclosure properties, reports the latest figures show that foreclosures were up 62% in April from the same month a year ago. At the current pace, 2007 foreclosures could hit the 2 million mark. Advertisement Other efforts by strapped homeowners -- such as "short sales" or loan restructuring -- can also trigger 1099-Cs reporting taxable income. Getting the short end of the stick In a short sale, a bank allows a delinquent borrower to sell the house for less than the mortgage amount and turn the proceeds over to the bank as payment in full. Scott Williams, a real estate agent in Roseville, Calif., near Sacramento, explains how it works: Say you lost your job and can't keep up payments on your home, you still owe $300,000 on your mortgage but the house value has dropped to $275,000. If the bank agrees to a short sale, you'd sell the place, pay the commission and other selling costs -- let's assume $15,000 -- and turn the remaining $260,000 over to the bank. The $40,000 gap between the payment and the amount due would show up on a 1099-C form as taxable income to you. That's right, even the $15,000 of selling expenses gets tossed in with the amount of forgiven debt on which you owe tax. (You report this "other income" on line 21 of the Form 1040.) Williams says he was actively involved in short sales in the 1990s housing slump in California, but that the practice pretty much disappeared for several years. Now it's back with a vengeance. He's already handled about ten short sales this year and has 40 more short-sale homes in his inventory, ranging in value from $180,000 to $600,000. Advertisement "Most of these cases are homes that were purchased within the past couple of years, at or near the peak of the market," he says. "Most were purchased with 100% financing or creative loans that after two years of artificially low payments, the loan adjusts to market rates. That can add hundreds of dollars to the payment and some of the people just can't plain afford it." Banks don't always agree to a short sale -- among other things, they look at the gap between the balance on the loan and the expected proceeds of the sale and the homeowner's other assets. But Williams says banks have become more receptive as the number of homeowners in trouble has grown. They weigh the cost of a short sale against the cost of foreclosing and selling the property themselves. "Banks don't do short sales because they want to be nice to people," Williams says. "They do them because they make business sense." Dodging the tax bullet There's a very important exception to the debt-relief-equals-taxable-income rule. Although lenders must send 1099-C forms reporting taxable income whenever cancelled debt is $600 or more, the tax bill itself is forgiven if the homeowner is bankrupt or insolvent. Advertisement Insolvency means your debts (including that mortgage) exceed the value of all your assets. Let's go back to the $300,000 mortgage and the $260,000 short sale. If you had no assets at all, none of the $40,000 of debt relief would be taxable. If you had more than $40,000 of assets in addition to your home, however, the full $40,000 would be taxed. What if you had $25,000 of assets in addition to your home? Then $25,000 would be taxable and the other $15,000 could be excluded from income under the insolvency rule. (You use IRS Form 982 to claim the exclusion.) Williams says most of the short sales he's been involved with actually result in little or no taxable income to the seller, because they have no assets. "They may have some furniture and a little equity in a car, but their big asset is their house," he explains. It's clear, though, that plenty of people get burned by the rule that taxes forgiven debt. Twice in recent history, in fact, Congress has passed laws giving some people a pass on forgiven debt, regardless of their assets. But don't think Congress is a softie: The exceptions were for victims who lost their homes due to the terrorists attacks of 9-11 or Hurricane Katrina. Legislation has been introduced in both the House and Senate to grant general relief to homeowners who lose their homes to foreclosure. The National Association of Realtors is solidly behind it. But, frankly, the prospects are not good. If you benefit from debt forgiveness after a foreclosure or short sale, be sure to make a careful inventory of your assets and liabilities at the time. You'll need it to claim an exception under the insolvency rule.