I recently spoke with a client in my Rome GA office who surrendered their house in Chapter 13 bankruptcy last year. About six months into their Chapter 13 bankruptcy, they converted to a Chapter 7 bankruptcy. This past week, they received a 1099A from their mortgage company showing that the debt was forgiven and suggested that they would be taxed by the IRS even though they filed bankruptcy.
Despite what they letter from the mortgage company may have said, my clients will not be taxed on their foreclosure of their house. Click here to read the IRS publication 4681 which clearly states that this is not a taxable event. I cannot imagine how frustrated they must have felt thinking they were going to be taxed on something they gave back to their creditor. Good thing they were able to contact their bankruptcy attorney and got a quick response.
Here is what you need to do if you have had a house foreclosed during the course of your Chapter 13 or Chapter 7 bankruptcy. The IRS says “to show that your debt was canceled in a bankruptcy case and is excluded from income, attach Form 982 to your federal income tax return and check the box on line 1a. Lines 1b through 1f do not apply to a cancellation that occurs in a title 11 bankruptcy case on line 2.” If you do not feel comfortable working with IRS forms, get a professional accountant to do the work for you. Don’t mess up your tax return.
Even if my clients had not been in bankruptcy, the foreclosure of their house most likely would not have been a taxable event. Under the Mortgage Forgiveness and Debt Relief Act, taxpayers can “exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.”
Also, if a person is insolvent (as defined by the IRS) at the time the debt is forgiven, they will not be taxed on the debt forgiveness. Insolvent means that the amount you owe on all of your debts exceeds the amount of everything you own.
3. How much does it cost to file?