Taxes for deficiencies on short sales/foreclosures for investor & homestead property

[Galaxy2020]

We had many rental homes we lost due to decrease in rents (increase in home ownership over Bush years) or lack of quality tenants, most recently. We are considering bankruptcy chapter 7 debt relief. I am concerned, though, regarding the deficiencies of our rental homes whether lost through short sale or foreclosure. I have read that 2012 is the end of the deficiency exclusion/exception by the IRS but looked through the publication and could not find this information. Is this true??? Also, we moved out of our homestead 1.5 years ago (we had been there for over 10 years) into a more affordable home and it has been sitting there vacant while the mortgage company has been unwilling to accept market value. Will we owe the deficiency on that home too (it will be huge)?

[HHM]

First, the exception you refer to only applies to "primary residence" so it is a non-starter for you anyway, and yes, the 2007 Mortgage Debt Forgiveness Act expires at the end of the year (2012). Note, the tax is only triggered if the bank forgives the debt. If the bank keeps trying to collect it, (which is an option), the tax is not yet triggered. They could try to collect for 2,,3,,4 + years, and then forgive it down the road, thereby triggering the tax at that point.

Side note, there are 2 tax issues when it comes to investment property and foreclosure.
1. Forgiven debt income, i.e. paying income tax on the deficiency. This is what you appear to be asking about.
2. Capital Gain: For investments properties, it is still "possible" to have a capital gain (or loss) on a foreclosure/short sale. Bankruptcy does not help in that scenario. You either have a capital gain or you don't.

The forgiven debt income issue will turn on when you file BK relative to when the foreclosure or short sale is "completed". There are 3 possibilities.

1. File BK BEFORE foreclosure or short sale. Result, NO TAX liability on "forgiven debt income" (aka the deficiency). The bankruptcy discharged the debt.
2. File BK AFTER the foreclosure/short sale is complete, but do so IN THE SAME TAX YEAR (e.g. foreclosure in Feb, 2012, BK in Aug, 2012). Result: gray area, some commentators state the BK protects you, others say it doesn't. I have not seen any cases on the issue one way or the other. I personally believe you are safe if you file BK in the same tax year as the foreclosure.
3. File BK AFTER the foreclosure/short sale is complete, and NOT IN THE SAME TAX year (e.g. foreclosure in 2010, file BK in 2012). Result: If you would be liable for the tax, you would need to pay it. The BK does not help.

Most conservative approach, file BK before the foreclosures are complete. Also, if you file BK FIRST, it doesn't matter when the homes are foreclosed, you still get the benefit of the BK and no forgiven debt income tax liability (e.g. file BK in 2012, foreclosure in 2014, you are still fine).

Also, BK is not the only exception to forgive debt income tax, there is the general insolvency exception as well. But if you are facing huge deficiencies, you NEED to file BK anyway to deal with the resulting debt.

I hope this helps.

[bcohen]

Like HHM said, there are no taxes on debt discharged in bankruptcy. So to avoid being 1099'd and having a non-dischargeable tax obligation, file BEFORE the properties foreclose or are short-saled.

[HHM]

Like HHM said, there are no taxes on debt discharged in bankruptcy. So to avoid being 1099'd and having a non-dischargeable tax obligation, file BEFORE the properties foreclose or are short-saled.

Just a quick clarification...getting a 1099 and being liable to pay tax are different events.

You may still get a 1099 even if you file BK, but the BK is the exception you claim on IRS form 982 to avoid paying income tax on the deficiency.

I just want to avoid any misunderstanding because this scenario happens often. Debtor file BK, assumes that is the end of it, and come Jan of the following year, receive a 1099 and freak out. No reason to freak out, the bank will generally still issue the 1099, all it means is you have to file IRS form 982 with your taxes. No big deal. But the BK does not actually prevent the issuance of the 1099.

[Galaxy2020]

Does this change after 2012? Is the IRS planning to change anything on form 982? I have heard attorneys advertising for their services on the radio insisting next year that things will be vastly different.

[HHM]

Does this change after 2012? Is the IRS planning to change anything on form 982? I have heard attorneys advertising for their services on the radio insisting next year that things will be vastly different.

In regard to this particular topic, there are few things that a scheduled to end this year.

2007 mortgage debt forgiveness act. This is the law that exempts a deficiency from a short sale or foreclosure on a debtor's primary residence from being taxable income.
HAMP et al. Nearly all the government sponsored mortgage modification programs expire at the end of the year.

In terms of filing BK, this really doesn't change too much in the big picture. The BK will still deal with forgiven debt income so long as the BK is filed prior to the foreclosure/short sale.
Mortgage modification programs expiring is good riddance, all it did was delay the inevitable for about 75% of those that sought assistance. You will still be able to file chapter 13 BK to stop foreclosure and strip second+ mortgages.