The 1099 Blues: Did the Sale or Foreclosure of Your Property Cause You to Over/Under State Your Taxes?
– by Steven M. Brechner & Paul J. Valentine.
he Arizona property market has caused no end of heart ache. With the sharp collapse of real estate many Arizonan homeowners were forced into either a short sale or a foreclosure. After that agonizing decision the 1099 shows up, suddenly their tax preparer tells them that they owe taxes – a lot of taxes. So the question today is: was that tax preparer correct? The answer is probably not.
So if you (1) short sold your property, or (2) suffered a foreclosure, AND your tax preparer / accountant / lawyer told you that you owed federal taxes, this article is for you.
Perhaps the most misunderstood portion of this process is the first step – whether the debt is recourse or non-recourse. In almost all instances, non-recourse debt will not be subject to cancellation of debt (COD) income. I repeat, in almost all situations, non-recourse debt will not lead to COD income.
And in Arizona, because of Arizona’s anti-deficiency statutes, most mortgages on real property are non-recourse obligations. That means that most Arizona mortgages do not create COD income. Thus, if your tax preparer mentioned cancellation of debt, or debt forgiveness you may be overpaying your taxes.
The root of the problem stems from incorrect 1099 forms filed by the mortgage lender. Following the short sale or foreclosure lenders should file a 1099 with the IRS that reports on the transaction. Here’s the way it is supposed to work:
- Form 1099 – A is used to report a repossession or foreclosure. If your house is taken back by the lender, the lender will report the FMV (fair market value) of the property received, the amount of debt they have on the property and check a box as to whether you are personally liable.
- Form 1099 – C is used to report Cancellation of Debt Income. For example, if the lender forecloses on your house for less than the debt, the lender can either come after you for the difference or forgive the debt. If the debt is forgiven, there is cancellation of debt income, which can be treated as taxable income.
The problem is that the lenders are routinely filing incorrect 1099 forms causing numerous taxpayers to file incorrect tax returns. To compound this problem, many taxpayers and tax preparers are getting the law wrong and thus not fixing the 1099 error in their tax filings.
This is a complicated area that is commonly misapplied. Unfortunately, here at Arboleda Brechner, incorrect advice on this issue is something we see all too often. That is why it is imperative, that you visit with a tax attorney familiar with distressed real estate who understands all the consequences of disposition of underwater property. If you have already filed your tax returns you may want to have a competent professional review them to insure there was no costly mistake. If your return does contain an error, in most instances, an amended return can solve the problem and lead to a potential refund from the IRS. Our law firm routinely handles these matters and would be happy to assist you resolve any costly mistakes.
- ANY FEDERAL TAX ADVICE CONTAINED IN THIS DOCUMENT SHOULD NOT BE USED OR REFERRED TO IN THE PROMOTING, MARKETING OR RECOMMENDING OF ANY ENTITY, INVESTMENT PLAN OR ARRANGEMENT, AND SUCH ADVICE IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES UNDER THE INTERNAL REVENUE CODE.
- Steven M. Brechner, Esq. (licensed in Arizona) & Paul Valentine, (licensed in Arizona and Massachusetts).
- The Supreme Court Case Commissioner v. Tufts held that non-recourse debt is included in the amount realized and not treated as cancellation of indebtedness. Thus, if there is any difference between basis and amount realized it is treated as a capital gain/loss. See also Treas. Reg. § 1.1001-2(c).
- There is only one instance when a non-recourse obligation can lead to COD income. In a situation where the lender accepts less than face value of the obligation and the debtor keeps the property, then there may be COD income for the debtor. See Revenue Ruling 91-31 and 82-202.