More Confusion Over the 1099-C

The last few weeks we’ve been flooded with questions about 1099-C and 1099-A forms sent to consumers who have defaulted on credit cards, auto loans, or mortgages. I’ve found it frustratingly difficult to get even basic answers to some of these questions. I’ve queried numerous tax professionals, and sometimes received conflicting advice. The Internal Revenue Service did not respond to my repeated queries.

But for two questions related to cancelled debt on real estate, I struck pay dirt when it dawned on me that I should try the National Association of REALTORS®. Sure enough, they pay close attention to tax issues that affect homeowners, and they were quick to respond to my questions.

The answers to these two questions were provided by NAR Tax Counsel Linda Goold. It’s important to emphasize that the information here is not a substitute for professional tax advice. If you have any questions about how to handle a 1099-C or 1099-A- related issue, I strongly recommend you get help from a qualified tax professional.

Question #1: Are HAFA Payments Taxable?

The Home Affordable Foreclosure Alternatives (HAFA) program provides homeowners who agree to sell their homes using a short sale with up to $3000 in relocation expenses. Will they have to pay taxes on those payments? A reader, Gayle, asked:

I did a short sale on my house last year and about $52K was the amount of the debt forgiveness. I also received $3000 for the Home Affordable Foreclosure Alternatives (HAFA/RASS) relocation assistance program. But I have not received a 1099C for this $3K and am not quite sure who to ask for it. Is this an amount that will be fully taxed?

Answer: Goold said in an email, “We’ve wrestled with this issue with Treasury for quite awhile” then went on to share the reply received from the Treasury Department Homeownership Preservation Office:

“While there is no IRS directive that I can point you to, the Internal Revenue Service has consistently held that governmental payments made under governmental programs for the promotion of the general welfare are not includible (sic) in an individual recipient’s gross income (general welfare exclusion). This includes borrower incentive payments received under any TARP program including the borrower relocation incentive under HAFA. However, to the extent that moving expenses are tax deductible, a borrower in a HAFA transaction must reduce the moving expenses by the amount of the relocation incentive before itemizing this expense. In other words they can’t double dip.”

How Does PMI Affect Forgiven Debt?

Some loans carry PMI—private mortgage insurance—a fee that the homeowner pays each month to protect the lender in the case of default. If a mortgage carrying PMI goes into foreclosure, the insurance company may have to pay the lender for some of the loss incurred. Does that affect the homeowner? Lauren wrote:

My question is if the PMI company protected the bank from part or all of the deficiency, shouldn’t the amount on my 1099-C be the deficiency less the amount this insurance covered? How is it fair that the bank can claim it as a loss if they were paid back?”

She says she’s asked the bank, loan officers, realtors and even her accountant and no one knows the answer. “Maybe banks are allowed to double dip!” she says.

My initial thought was that the loss that the bank suffers and the amount reported on the 1099-C (or 1099-A as the case may be) are separate matters. The IRS requires the lender to report forgiven debt on a 1099-C because it considers that amount income to the borrower. The IRS expects the taxpayer to include it in her taxable income, unless she can show that she qualifies for an exclusion such as the insolvency exclusion or the Mortgage Debt Relief Act exclusion.

Goold’s response confirmed my initial reaction. She wrote: “The only thing reported is the amount that the lender forgave. The borrower has to include the forgiven debt (as provided on the 1099C) on Form 982 with the regular 1040 tax return, but the income isn’t taxed (so long as they meet the criteria for tax-free treatment). The PMI payment is completely separate from that. Usually the PMI payment goes to the lender, not the borrower. But if the bank forecloses and the PMI pays the lender later, then the questions about whether it’s income would go to the lender, not the borrower…Net or gross, the amount paid to the lender wouldn’t affect the borrower’ tax return.”

In my next installment, I tackle the problem of 1099-Cs being sent for very old debts: 20 years in one case! Stay tuned.

For more advice on how to handle 1099-Cs read What is a 1099-C? Your Top 11 Questions Answered.

Image: katerha, via Flickr.com