Monday, August 20, 2007

Foreclosing Mortgage Lender Screw-Up Results In Whopping IRS Tax Bill For Ex-Homeowner

The New York Times reports on a story that, in my view, may already be occurring with great frequency all over the country given the current real estate market conditions. The issue involved here is the liability to pay Federal income tax that a homeowner has when a foreclosing mortgage lender acquires title to the home at a foreclosure sale and subsequently forgives or cancels the homeowner's remaining balance on the unpaid loan.

According to the story, a Pennsylvania homeowner lost his home at a foreclosure auction two years ago where, due to the fact that there were no interested third party bidders, the lender, Wells Fargo Home Mortgage, acquired title to the home for a nominal bid of $1. Reportedly, the outstanding loan balance was approximately $106,000. On July 8 of this year, the now ex-homeowner received a tax bill from the IRS for $34,603 for back taxes, penalties, and late fees on the cancelled debt.

After some investigation and inquiry, it turns out that the value of the home acquired by Wells Fargo at the foreclosure sale was, in fact, higher than the amount the homeowner owed on the unpaid loan. After reviewing the matter, Wells Fargo said last week that it would be filing a corrected 1099 tax form to show that no debt had been cancelled, because the fair market value of the home was actually more than what was owed.

In addition to this story, there is a brief anecdote in the article about another homeowner who received a tax bill from the IRS after losing a home in foreclosure who was able to avoid paying the tax by proving that she was insolvent at the time of the foreclosure sale.

For more, see After Foreclosure, a Big Tax Bill From the I.R.S. (same article also available here).

Postscript

Prior posts on this blog have referred to employing the "insolvency exception" to minimize or altogether avoid paying income tax on a debt cancellation resulting from a foreclosure sale or short sale (see Dodging The Income Tax On Foreclosure & Real Estate "Short Sales"), as well as the "bankruptcy exception" and other exceptions to the general rule that tax is owed on the amount of debt cancellation (see Debt Forgiveness On "Short Sales" Not Always Subject To Income Tax).

What's instructive about today's New York Times article is that it provides strong support for the proposition that (at least when foreclosure sales are involved) you can't just assume that the Form 1099 was correctly prepared by the mortgage lender. Before you even reach the issue of whether the rule exceptions are applicable, one must first question whether the foreclosing lender properly calculated the amount of income from debt cancellation and, if not, one must then get the lender to reissue a corrected Form 1099 to the IRS reflecting the correct amount. Too often, a taxpayer will just assume that whatever number appears on a Form 1099 is correct.

(Note to mortgage lenders: When you take title to foreclosed property at a foreclosure or trustee's sale for a nominal winning bid - ie. $1, $100, etc. - or for an obviously less than market value bid, the amount of debt cancellation is based on the amount that the unpaid loan exceeds the property's fair market value on the day of the foreclosure sale, not the nominal bid.)