Unexpected consequence of home foreclosure

The Housing Bubble Blog links to a story pointing out that "“Homeowners should know that although debt can be forgiven, it’s never forgotten. When a short sale, deed-in-lieu agreement or foreclosure occurs and a residential lender loses money on a loan, the lender will most likely file the loss with the IRS, and the former homeowner may end up owing thousands of dollars in taxable income.”

“‘That’s probably where we see kind of the biggest surprise on the part of our clients,’ said Jackie Pearlman, senior tax research coordinator for H&R Block. ‘Not only are they not aware it existed but are very surprised to understand that it’s income. The concept is really alien to many people.’”

“‘We all know intuitively that if you borrow money you don’t have the income,’ said Bill Purdy, a Soquel-based attorney in Santa Cruz County who represents clients with home lending problems and foreclosures. ‘If you don’t have to pay it back, it can become income.’”

“But if the lender takes a loss selling a property, let’s say $100,000, the company will file with the IRS, and the client will receive a 1099-C for the amount.”

“Purdy said many people try to ignore the problem. ‘The problem is that people do nothing,’ he said. ‘They freeze like deer in headlights.’”

“But none of this matters to the IRS, which knows only that a 1099-C was distributed as taxable income. ‘They will assume it’s taxable until informed otherwise,’ he said. ‘And you don’t want to wait for that notice in the mail.’”

“Adarsh Sangani, director of residential lending for Fremont Bank, said his bank doesn’t issue many 1099-Cs to its customers. ‘Only if a customer doesn’t respond to collection calls, a letter and a collection agency,’ he said.”

I think what is being referred to here is even though the bank makes a short sale, the homeowner still had a paper profit based on their original purchase price on the home; that is what becomes potentially taxable income.

Update: Michael Shedlock also has flagged this nasty surprise for homeowners who have to exit their home through a short sale: "One in five sales is a short sale. That is pretty staggering. It will be interesting to watch this trend develop. What is clear is that lenders do not want those homes back. Equally clear is there are likely to be some huge tax consequences for forgiveness of debt some time down the road."