Q: I am hoping you can clarify debt relief as it applies to rental property. My sister has a single-family residence that she rents out, and is now letting the house follow the path to foreclosure. She received info from a real estate attorney that didn't make sense to me nor could I find any information that substantiated the info.
He indicated that she would not have to pay any tax if the house sold at a foreclosure sale for less than the mortgage.
I can only find information about not having to pay tax (or relief of tax debt) if the property is your primary residence. I can't find any information that applies to a rental property.
A: I cannot provide specific legal advice in my column, so I narrowed your question to the one issue: Does the mortgage forgiveness law apply to investment properties? And the answer is no.
If you have a mortgage loan that is foreclosed upon, if the sale does not generate enough money to pay off the loan balance, you may have to pay income tax on the difference between the sales proceeds and the loan balance. The IRS (and tax law) calls this canceled debt taxable income; I call it phantom income.
There are several exceptions where such canceled debt is not taxable. If you file for bankruptcy relief, debts discharged by the bankruptcy judge are not considered taxable income. If you are insolvent when the debt is discharged, there is no tax to pay.
In 2007, when foreclosures started escalating, Congress enacted the Mortgage Debt Relief Act. This new law excludes from income any loan modification or any deficiency created when a house is foreclosed.
Although the law initially was to expire at the end of 2012, Congress extended the deadline to the end of 2013.
However, the law applies only to debt that is canceled on your principal home. So depending on how much the canceled debt will be, your sister may want to find another approach. She can do a short sale, which most likely will trigger some phantom income, but hopefully such a sale will generate more revenue than a foreclosure. She can also consider filing for bankruptcy relief.
The IRS has a publication that is fairly helpful. (Publication 4681, "Canceled Debts, Foreclosures, Repossessions, and Abandonments," available free at irs.gov/publications.
Q: My daughter this year went through a deed in lieu with her lender for her condo in Illinois. Is it likely she will receive a Form 1099 for the amount of the mortgage that was owed at the time of the foreclosure? If so, is it possible to prevent the bank from filing and sending a 1099?
A: Your question turns out to be a follow-up on the question above, so I also refer you to IRS Publication 4681. If I understand your concern, you would prefer that the IRS not know of the deed in lieu, so that your daughter will not have to pay what I have called phantom income.
But I have some good news for you. If the debt cancellation is more than $600, which I assume is the case, the lender must send out Form 1099-C (C for cancellation) by the end of January. That form will show the amount of the debt that presumably was canceled. Your daughter will have to file Form 982 with her 2013 income tax return.
But if the condo was your daughter's principal residence, then under the Mortgage Debt Relief Act your daughter does not have to pay any tax on this phantom income. According to the IRS, "if you are using (Form 982) only to report the exclusion of forgiveness of qualified principal residence indebtedness … you only need to complete lines 1e and 2."
Note that I used the word "presumably" was canceled. There is a legal question working its way through courts, asking whether the lender, by sending in a Form 1099, really has canceled the balance of the loan.
My advice to anyone engaged in a short sale or a deed in lieu is to get a statement in writing from the lender that you will be relieved of all further obligations and that the promissory note that you initially signed when you obtained the loan will be marked "paid and canceled" and returned to you.
Benny L. Kass is a practicing attorney in Washington and Maryland. No legal relationship is created by this column. Send questions to email@example.com.