I recently received an email from a very concerned Chapter 7 client who I represented in 2006. My client had suffered a fairly drastic reduction in his income and as part of his Chapter 7, he surrendered his home, which has a fair market value of approximately $650,000. There were no objections in this case, and my client received his discharge as a matter of course.
Around the first of February, 2007, my client received a 1099 from the mortgage company showing that $599,000 of debt was forgiven. I checked with my colleague, CPA Scott Rittenberg, who advised me that in a non-bankruptcy context, a homeowner who sells or loses a home to foreclosure could be liable for taxes on the difference between his basis in the home (in this case around $500,000) and the forgiveness ($599,000). Would my client be looking at an income event in the amount of $99,000?
Scott did note that if my client had been in his home for two years or longer there was a $250,000 exclusion that applied, but absent a two year stay, there could be a tax problem. Scott advised me to look further to research the rules about how a bankruptcy might change things.
I did a quick search on the BankruptcyLawNetwork blog and I found this post that answered by question about the tax treatment of a forgiveness of debt in bankruptcy by my colleague, attorney Cathy Moran of Mt. View, California. Cathy publishes a very comprehensive and informative California bankruptcy law web site that speaks to many consumer bankruptcy issues.
Cathy advises that if you get a 1099, you should file a Form 982 to advise the IRS that the debt forgiveness occurred in bankruptcy and has no tax consequences.
2008 Update: you can read another informative post about the tax treatment of debt forgiveness in a bankruptcy on Taxgirl’s blog in a post entitled “Foreclosures, Debt Forgiveness and Mortgage Losses Explained.” Click on the link to read this post.
Needless to say, my client is much relieved by the answer to his question. Tax consequences arising from a deed in lieu of foreclosure in a non-bankruptcy setting could have significant and unintended consequences. If you have option of executing a deed in lieu vs. a bankruptcy, keep the tax issues in mind.