Borrowers, Not Banks, Taxed on Mortgage Settlement Payments

If you are one of the more than 1.8 million people who have received a check from the Independent Foreclosure Review (IFR) settlement — or if you have one coming — don’t spend it all in one place. These payments are considered taxable income for state and federal income tax purposes and come tax time, Uncle Sam or your state taxing authority will want their share.

Here are the various ways these payments may be taxed:

Base payments: The base payment is a lump sum amount that doesn’t reimburse the taxpayer for any particular amount. If the amount is $600 or more, it will be reported to the IRS using form 1099 MISC. Keep in mind this is not canceled debt, so the Mortgage Debt Forgiveness Tax Relief Act exclusion that allows many taxpayers to exclude canceled or forgiven debt from their income does not apply here.

Return of Interest Paid: Here, some of the interest that was paid to the lender previously by the borrower is refunded. If the amount is $600 or more, a Form 1098 reporting this amount will be filed with the IRS. If the taxpayer previously deducted mortgage interest, this amount may be taxable. Here’s how the IFR website explains it:

If the borrower previously deducted mortgage interest on the loan that is the subject of the payment, then the payment may be taxable in the amount of the tax benefit the borrower received from a mortgage interest deduction in a prior year.

I can already anticipate some of the questions this one will generate. Who determines which year of interest this refund covers? Does this mean the taxpayer amends a previous year’s return to back out that deduction, or report it as interest received in 2013 — or both? This may create all kinds of confusion.

“Absent any further guidance from the IRS, I would say it would be taxed as interest income,” says Marina Parkin, CPA, a partner with Koontz & Parkin. “I don’t anticipate the need to go back and amend the returns.”

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Return of Equity: Here, the borrower is reimbursed for lost equity. No 1099 will be issued but the IFR website warns that “the amount may still be subject to taxation depending on the borrower’s individual circumstances.”

Interest on Other Payment Components: If the settlement required that interest be paid on any of the other payments (such as base pay, for example) and the amount is $600 or more, it will be reported on a 1099 INT. That’s the same form you receive if you earn interest on your savings or checking account. Again, it may be taxable.

Return of Fees You Paid: This amount won’t be reported to the IRS. Again, however, borrowers are given a vague warning that these amounts may be taxable.

Tax Withholding: Some payments may have already been issued with taxes withheld. As the IFR website explains:

If a borrower does not return tax information on the Form W-9 as requested by the Paying Agent, then the Paying Agent is required by law to automatically withhold certain amounts. These amounts will be subtracted from the borrower’s payment and noted in the letter enclosed with the check. The Paying Agent will report such amounts to the IRS and to borrowers on a Form 1099 MISC and/or a Form 1099 INT. The Paying Agent will deposit the amounts withheld on the borrower’s behalf with the IRS or the appropriate state agency and mail the Form 1099 MISC and/or a Form 1099 INT to the borrower in the first quarter of 2014.

I can’t wait to see how this one turns out. The Paying Agent, Rust Consulting, has already had problems with bounced checks and failure to correct addresses for recipients, so it will be really interesting to see how they manage to correctly handle the tax withholding, and fix mistakes.

Legislation that would exempt these payments from taxes was introduced in Congress last year, but did not pass and no similar bills appear to have been introduced yet this year.

The IRS may issue further guidance by the time taxpayers must file their 2013 returns. But if it’s anything like the instructions for 1099-C and 1099-A forms, more than a few people will feel lost, and may have to hire a tax professional to assist them.

Parkin’s current view is that taxpayers will have to report the income based on the type of 1099 issued. “If a 1099-INT is issued, the income has to be reported as interest and if 1099-MISC is issued, income would show up on the ‘other income’ line of the tax return.” She raises the possibility of another potential snag for those who prepare their own returns: “Make sure when you include the amount in ‘other income’ that you don’t accidentally make it subject to self-employment tax as that income goes on the same line of the tax return.”

The good news (if it can be called that) is that many settlement checks are for relatively small amounts — $300-$500 seems to be the norm — which means no 1099 will be issued to those recipients. Still, they should keep in mind that the IRS requires taxpayers to report all taxable income even if a 1099 isn’t issued.

For those who endured a foreclosure or short sale and have already grappled with a 1099-C and/or 1099-A form reporting canceled debt, the new 1099 and the tax bill that may result from it adds insult to injury. “It’s just a never ending story for those affected,” observes Parkin.

In the meantime, the banks’ armies of corporate tax pros don’t have to worry about the pesky issue of taxes on the settlement: they’ve been given a free ride and get a tax deduction for these payments. “It’s kind of a hidden give-back to the wrongdoers,” says Phineas Baxandall, Ph.D., Senior Analyst and Program Director for Tax and Budget Policy for U.S. PIRG, an advocacy group that is fighting to close corporate tax loopholes like this one.

“There’s something really perverse about that,” he adds. “The folks who have done nothing wrong have to pay taxes on income that was meant to restore the way things really were, whereas the company that committed wrongdoing gets a taxpayer subsidy.”

Image: iStockphoto