The “1099 Blues”: Did the Sale or Foreclosure of Your Property Cause You to Over/Under State Your Taxes[1][2]

          The Arizona property market has caused no end of heartache. With the sharp collapse of real estate many Arizonan homeowners were forced into either a short sale or a foreclosure. After that agonizing decision, 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.[3] I repeat, in almost all situations, non-recourse debt will not lead to COD income.[4]

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.