What happens to the deficiency that results when you do a short sale or the bank forecloses on a property? Good question! The deficiency that results has to be accounted for in some manner as it is really an accounting matter. Whether you do a short sale or a foreclosure or deed in lieu (a friendly foreclosure) the resulting deficiency is handled in one of two ways either as a deficiency judgement or as a taxable event that results in the issuing of a 1099C.
The deficiency judgement once issued by the bank is for 100% of the amount of the difference between what is owed and what the bank sells the property for. The only way for it to go away is to pay it in full over time plus interest OR file for bankruptcy.
If the bank chooses to treat the deficiency as a taxable event, they will issue a 1099C. The full amount is recorded as phantom income and added to your reported income and is taxed at your current income tax bracket. It is a one-time event and is a better alternative to the deficiency judgement as it is only a percentage of the total amount owed. The IRS form 982 can be completed and attached to your 1099C when you submit your taxes and if you qualify for the IRS rules of insolvency the Federal Government will waive the taxable amount as a result of the Mortgage Forgiveness Debt Relief Act of 2007.
To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.
Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Form 982 provides more details about these provisions.