Homeowners in foreclosure might face an income tax liability

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When he could no longer make payments on his home in Allentown Pennsylvania, and the lender, Wells Fargo, foreclosed on his $106,000 mortgage in 2005, William Stout thought he could make a fresh start, according to a report in The New York Times. But in July, Stout and his new wife received a bill from the Internal Revenue Service for $34,603 in taxes, penalties and late fees on income resulting from Cancellation of Debt (COD).

Wells Fargo was unable to sell the home at auction at the time and purchased the home for $1. Wells Fargo reported the cancellation of debt to the IRS as required. The IRS billed Mr. Stout for failure to pay taxes on COD income.

Tax on cancellation of debt is not well understood, and more taxpayers will likely be receiving notices of unpaid taxes as the numbers of foreclosures increase, said Ellen Harnick, senior policy counsel at the Center for Responsible Lending, a nonpartisan research and policy center in Durham NC, according to the Times report.

Foreclosure is not the only way the homeowner can incur a tax liability in a declining real estate market. When a homeowner is forced to sell his home for less than the outstanding mortgage balance and the lender forgives the difference owing on the mortgage, the homeowner has taxable income on the amount forgiven.

The lender who assumes the property in foreclosure is required to file a 1099-C, Cancellation of Debt, with the IRS and the former homeowner. Among other things, the form names the debtor, lists the amount of the debt forgiven, and shows the fair market value of the property. The cancellation of debt is the difference between the mortgage liability and the fair market value of the property that the lender acquires when the loan balance exceeds the FMV.

In some cases, a taxpayer may be responsible both for income from the cancellation of debt and a gain on the sale of property in a foreclosure. The IRS cites the following example on its Web site

"If the face amount of the recourse debt is $200,000, the FMV of the property is $170,000, and the adjusted basis is $120,000, you have $30,000 of COD income ($200,000 debt less $170,000 FMV) and $50,000 of gain ($170,000 FMV (amount realized) less $120,000 adjusted basis)."

A loss on the sale of a home through foreclosure is not deductible.

Stout's attorney appealed his case, saying that Wells Fargo was eventually able to sell the home to another lender for $106,000, the value of the Stout debt.

Stout was one of the lucky ones. Well Fargo Home Mortgage told the Times last week that it had reviewed Stout's case and was filing a corrected 1099 to show that no debt was cancelled because in fact the value of the home was more than the mortgage balance.

Debts cancelled in bankruptcy or because of insolvency are not considered taxable income. Taxpayers who are not required to pay tax on discharged debt should file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with their income tax return.

"If you can prove you are insolvent, the IRS does not treat the forgiveness of debt as income," Diane Thompson, a lawyer in Godfrey Illinois told the Times.

In some cases in the current real estate crisis, lenders and mortgage brokers might have urged consumers to take out mortgages for properties that were overvalued. It's possible the I.R.S. will consider this situation on appeal.

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