While it may seem cruelly ironic, when a creditor forgives a debt, the Internal Revenue Service assumes it's taxable income. In the case of a house foreclosure, not only do you lose your property, you also may owe the IRS money come tax time. The bottom line: If you receive a 1099-C, regardless of whether the loan in question was recourse or non-recourse, don't ignore it. Even if the forgiven debt is exempt from income taxes, it must still be reported to the IRS.
When you have a mortgage, your home serves as collateral in case of default. At closing, the lender places a lien on your property. If you fail to make your payments, the lender is legally entitled to foreclose on your home. A home foreclosure is bad news all around; the lender may sell your home for less than you paid for it, and your credit score will take a nose dive.
A Workable Compromise
To avoid the long and unpleasant process of a foreclosure, a lender may allow you to turn over deed to the property in exchange for a release of its lien. This arrangement is known as a deed in lieu of foreclosure. But, the difference between what you owe on the property and its fair market value is considered to be taxable income by the IRS.
Form 1099-C is used to report the cancellation of a debt. Like all documents that report income to the IRS, the form, issued in conjunction with a deed in lieu of foreclosure, must be sent out by the last day in January of the following year. For homeowners in this situation, knowing what to do next is as important as knowing when to expect the 1099-C in the mail.
Location Is Key
State law determines the way that a lender treats a mortgage default. If a property is located in a recourse state -- meaning that the lender has some options to pursue those who default on mortgages -- it can sue you to recover the deficiency, the amount you owe, or issue a 1099-C. If the property is located in a nonrecourse state, the lender can't sue you for the deficiency and the forgiven debt in a deed in lieu of foreclosure isn't considered taxable income.