Excluding 1099-C Cancellation of Indebtedness Related to Home Foreclosure from Income

Many of my clients are angry at the way they are being treated by the IRS or based on their perception of the lack of fairness of the tax laws. The most distraught clients are those that receive 1099-C’s or 1099-A’s in the January following the year in which their home has been foreclosed, and realize that they could owe hundreds of thousands of dollars in taxes to the IRS for the cancellation of their debt. Being taxed hundreds of thousands of dollars for losing your home is perhaps the best example of adding insult to injury. Fortunately, many taxpayers can advantage of special exemptions to prevent the recognition of cancellation of income and save themselves a SIGNIFICANT amount of money in taxes.

Being taxed hundreds of thousands of dollars for losing your home is perhaps the best example of adding insult to injury. 

Qualified Principal Residence Indebtedness 

Canceled debt that is qualified principal residence indebtedness can be excluded from income. Debt that counts as qualified principal residence indebtedness includes a mortgage to buy, build, or substantially improve your home. Qualified principal residence indebtedness also includes a loan used to refinance a mortgage that you used to buy, build, or substantially improve your home, but only up to the amount of the principal of the old mortgage prior to refinancing.

I know that many people use part of their mortgage or loan proceeds from refinancing to purchase personal property, such as cars or boats or furniture, or to pay off other debts, such as credit card debits, instead of using the all of the loan proceeds to purchase or remodel or improve their property. These amounts do not count as amounts that you exclude from income as qualified principal residence indebtedness, and these amounts are counted first by the IRS when calculating whether you can take advantage of the Qualified Principal Residence Indebtedness exclusion. This exclusion is further limited in that the maximum amount that you can treat as qualified principal residence indebtedness is $2 million.

There is another exclusion that is more flexible than this exclusion, and can even be used in combination with this exclusion…

Insolvency Exclusion

The insolvency exclusion is a very useful exclusion. Under this exclusion, you can exclude canceled debt from income to the extent that you were insolvent immediately before the cancellation event. This amount is calculated by adding up the fair market value of all of your assets and subtracting this amount from the total of all of your liabilities. The resulting figure is the extent to which you can exclude cancellation of indebtedness income from your income. Since taxpayers usually do not have too many assets by the time their home is being foreclosed on, and since the home is usually the taxpayer’s biggest asset, a taxpayer can often exclude close to the entire amount of their cancellation of indebtedness income from their income.

Conclusion

Don’t be discouraged if you receive a 1099-C in your mailbox in January. Call us, schedule a free 30-minute consultation, and we will see what we can do to help ease or eliminate your possible tax burden.