The most common mistakes made when California homesellers report the discharge-of-indebtedness income on shortsales or foreclosure sale discounts are:

  • lender error in the discounted amount on 50% of 1099-C (cancellation of debt) forms lenders filed;
  • shortsale homesellers failing to properly report by using an Internal Revenue Service (IRS) Form 982;
  • homesellers improperly claiming insolvency under Internal Revenue Code (IRC) §108 to exclude discharge-of-indebtedness income; and
  • homesellers failing to report and include Internal Revenue Service (IRS) Form 982 disclosing the discharge-of-indebtedness income.

first tuesday take: Discharge of indebtedness income on payoff of a mortgage at a discount is of concern to negative equity sellers and seller’s agents in three situations:

  • short payoffs for sales of principal residences;
  • mortgage discounts on all types of property other than principal residences; and
  • insolvency with a discount on a payoff.

For reporting discounts on purchase-assist and improvement (nonrecourse) loans, the owner closing a sale of his principal residence no longer adds the amount of the lender’s discount to the price paid by the buyer to set the price realized on the sale — as has been the rule since the 1930s.

Instead, the discount on purchase-assist and home improvement loans produces a “personal loss” (capital loss) on the sale that cannot be written off. However, the lender will file a 1099-C indicating the discount occurred, reporting it as debt relief that is otherwise taxable, except for the negative equity home sales rule. [Internal Revenue Code §108(e); for information regarding short sale transactions, see the September 2011 first tuesday article, How to facilitate a shortsale transaction.]

For the sale of all properties other than a principal residence, and for all loans other than a purchase-assist or refinance of the purchase-assist debt on a principal residence, the debt discharged — the discount — will be subject to ordinary income tax rates— unless the loan has nonrecourse purchase-money status under California antideficiency law.

Property owners subject to a trustee’s foreclosure must watch out for lender foreclosure retaliation. On a foreclosure sale other than a single family residence (SFR), lenders might underbid instead of making a full credit bid when no other bidders are present or willing to pay the full amount due.

Then, as compelled by state anti-deficiency law, they are forced to write-off the balance of the bid. This triggers lender reporting to the IRS on Form 1099-C of the amount of the loss due to an underbid, essentially shoving the lender’s uncollectible loss onto the property owner by creating a tax reporting complication for the property owner which provides the lender with no benefits, save retaliation.

Property owners other than homeowners are the ones placed at risk of owing taxes on this maneuver. But they have a number of avenues available to them to force their lender to make a full credit bid in order to take the property — filing bankruptcy comes to mind.

Many of the most common mistakes made by property owners in any of these situations are remedied by hiring an accountant familiar with the rules regarding discharge-of-indebtedness income. Seller’s agents: make sure your shortsale homeseller knows that discharge-of-indebtedness income reporting applies to their shortpay situation.

Re: “Cancellation of Debt Review by Audit” from the Franchise Tax Board