Since the recession started in 2007 people facing foreclosure of their primary residence were concerned mostly with deficiency judgments against them personally. Deficiency judgments mostly did not materialize as first mortgage holders rarely have pursued personal judgments. This year, the homeowners’ concerns are tax related.
When a first mortgage lender did not pursue a deficiency or accepted a deed in lieu of foreclosure and liability a homeowner has received income for tax purposes in the amount of the debt forgiveness. Congress passed a law when the recession started that waived recognition of income for debt forgiveness when the forgiveness related to the taxpayer’s home mortgage.
The law protecting people from imputed taxable income by virtue of forgiveness on personal liability on their home mortgage expired on January 1 of this year. People who lose their homes to foreclosure and who escape a deficiency judgment now face a significant income tax problem. The difference between the home’s value and the mortgage balance will be recognized as taxable income if the bank does not pursue a deficiency and instead issues the homeowner a tax form 1099 for debt forgiveness. The lender will usually issue a 1099 to the owner so as to report debt forgiveness to the IRS and claim an equal taxable loss for a bad debt.
Without the tax law waiving imputed income, the only way for the homeowner to avoid tax liability is to claim insolvency on his tax return. Filing bankruptcy creates a presumption of insolvency for tax purposes. Many homeowners will find that they need to file bankruptcy after a foreclosure, not to protect against a deficiency judgment, but to avoid substantial tax liability.