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Home Foreclosures: 10.5.3 Steps Homeowners Should Take

The former homeowner should evaluate other parties’ claims to the surplus. A successful challenge that reduces the amount to which a lienholder is entitled increases the share available to the homeowner, unless even the reduced amount going to junior lienholders uses up all the surplus. In particular, review lienholder claims for fees and costs associated with foreclosure,381 or a lienholder’s failure to properly rebate pre-computed interest or insurance premiums.

Home Foreclosures: 10.5.4 Relative Rights of Judicial Lien and Homestead Exemption

While most holders of a lien based on a security interest take priority over the homeowner as to recovery of the surplus, this is not the case with a judicial lienholder. The debtor’s homestead exemption, if provided under state law, should be paid ahead of any claims of judicial lienholders.384 Consider, for example, a $100,000 surplus, a $50,000 lien following a judgment on credit card debt, and a $90,000 homestead exemption.

Home Foreclosures: 10.5.5 “Surplus Retrieval” Consultants

During the current foreclosure epidemic, a cottage industry of “surplus retrieval” consultants has emerged. These scammers offer a “service” of assisting distressed homeowners through the maze of procedures surrounding a foreclosure sale. The consultants typically end up with a lion’s share of any surplus, or simply take money from financially strapped homeowners when there is no likelihood there will ever be a surplus.

Home Foreclosures: 10.7.2.1 When Is a Gain Taxable?

For tax purposes, a foreclosure sale, repossession, deed in lieu, or voluntary return of the property is treated the same as a voluntary sale.432 If the amount realized at the foreclosure sale is greater than the taxpayer’s basis in the property, there may be a taxable gain.433 The gain is recognized when the homeowner’s rights are cut off—usually at the foreclosure sale, but potentially at the expiration of the redemption period, if that is in a later tax year.

Home Foreclosures: 10.7.2.2 Calculating the Amount of the Gain

The gain is measured as the difference between the amount realized at the foreclosure sale and the homeowner’s adjusted basis. The homeowner’s adjusted basis includes the purchase price of the property, including any purchase money mortgages, plus the cost of any capital improvements made to the property by the homeowner.440 The basis does not include costs of routine repairs or maintenance, even if performing the repairs increases the value of the home.

Home Foreclosures: 10.7.2.3 Lenders Reporting of the Amount Realized

Lenders should send the taxpayer a Form 1099-A showing the foreclosure bid, the outstanding mortgage debt, and the lender’s fair market valuation of the property. If taxpayers disagree with the lender’s valuation of the property, they should request that the lender prepare an amended Form 1099-A. The taxpayers should also be prepared to submit evidence of the actual fair market value and should maintain this evidence in their tax files.

Home Foreclosures: 10.7.3.4 When COD Need Not Be Reported

Discharged debt less than $600 need not be reported.460 Discharged interest and fees also need not be reported,461 although they may be reported.462 There is no penalty imposed on creditors for failing to report discharged disputed debt,463 and creditors should not report debt that was never due and owing.464 Debt that is discharged by operation of law (

Home Foreclosures: 10.7.3.5.1 What is a Form 1099-C?

Under the Internal Revenue Code, lenders must file Form 1099-C to report most discharged debts.469 A Form 1099-A should not be used to report COD, but only the amount realized from a transfer of the property.470 Nonetheless, sometimes a Form 1099-A will be interpreted by the IRS as reflecting COD income.

Home Foreclosures: 10.7.3.5.3 Improper filing of a Form 1099-C; use of a Form 1099-C to defeat collection actions

Compliance with Form 1099-C reporting is not a safe harbor from state or federal debt collection practices claims.485 Intentionally false or misleading Form 1099-Cs, or the threat of filing a Form 1099-C, may be grounds for claims based on federal or state fair debt collection practices.486 Filing a false Form 1099-C is unlikely to give rise to claims under the Internal Revenue Code for filing a false information return with the IRS, because Form 1099-C’s are not listed among the covered returns

Home Foreclosures: 10.7.3.6 Taxpayer Reporting: Form 982

Individual taxpayers have an independent obligation to report discharge of indebtedness income to the IRS, whether or not the lender issues a Form 1099-C. Practitioners should advise taxpayers, if there is reportable discharge of indebtedness income, to file a 1040 and attach Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). Form 982 allows taxpayers to claim applicable exclusions from COD income.492

Home Foreclosures: 10.7.4.2 Insolvency Exclusion

COD income is excludable from gross income if the taxpayer is insolvent prior to receiving the discharge, to the extent of the insolvency.498 Insolvency is defined as an excess of liabilities (including the debt being discharged) over the fair market value of assets, as determined immediately prior to the discharge.499 COD income greater than the insolvency is not excludable.

Home Foreclosures: 10.7.4.4 Disputed or Contingent Debts

Debt that was never owed or for which repayment was contingent on some future event does not generate COD income upon discharge. For example, the release of a guarantor does not generate COD income to the guarantor.512 Similarly, if a statute voids the debt, the IRS will generally permit the discharge of that debt to be excluded from income.513 Thus, the reduction in principal due to a successful Truth in Lending rescission claim should not be included in income.

Home Foreclosures: 10.7.4.6 Purchase Price Infirmity Doctrine

A purchase price reduction is not taxable income if property is bought at an inflated price on credit, and the originating lender or assignee lowers the indebtedness as a direct result of a legitimate argument contesting the purchase price, provided the borrower did not participate in any fraud in agreeing to the purchase price originally.525

Home Foreclosures: 10.7.4.7.2 Ordering rule for home equity debt

A discharge in the case of refinanced home mortgage debt will normally consist of mixed acquisition indebtedness (the principal amount of the old loan) and home equity debt (the fees and remaining principal on the new loan, possibly including such items as consolidated credit card debt).

Home Foreclosures: 10.7.4.7.3 Government payments to reduce principal

The now expired Home Affordable Modification Program (HAMP) Principal Reduction Alternative (PRA) is one example of a program that provides government payments to help reduce a homeowner’s principal. This reduction in principal are excluded from income under the general welfare exclusion.538 The general welfare exclusion excludes from income payments under government social benefit programs for the promotion of the general welfare and not for services rendered.539

Home Foreclosures: 10.7.5.1 Overview

When a taxpayer receives a Form 1099-C, the taxpayer, their attorney, tax return preparer, or accountant must make an independent analysis, distinct from that performed by the creditor, about whether the discharge must be included as part of the taxpayer’s gross income, or whether one of the exclusions applies. If the discharged debt is inadvertently included by the taxpayer as income, it will be subject to tax.

Home Foreclosures: 10.7.5.3 Preventing Submission of a Form 1099-C

A settlement agreement involving debt forgiveness should address whether the creditor will submit a Form 1099-C and in what amount. Settlement agreements should also establish any basis for excluding the discharged debt from income. For example, if the consumer will seek to exclude the discharged debt as qualified principal residence indebtedness, the settlement agreement should specify that the debt is being discharged because of the taxpayer’s financial condition or because of a decline in the property value.