Mythbusting: debunking the tax myths of foreclosures, short sales.

• Author: Fogel, David M.
• Position: Taxationissues

in light of practical problems tax practitioners face in reporting foreclosures and short sales, the following busts the top 10 myths surrounding these transactions.

Myth No. 1: Debt wasn't canceled because lender issued a Form 1099-A.

A lender who acquires property, but does not cancel any debt, is required to issue Form 1099-A (IRC Sec. 6050J). A lender who cancels at least $600 of debt must issue Form 1099-C [Sec. 6050P; Treas. Reg. Sec. 1.6050P-1(a)]. In many foreclosures, lenders have issued Form 1099-A, but not Form 1099-C. That means the lender didn't cancel any debt.

Wrong: In California, lenders can choose between the judicial or nonjudicial foreclosure process.

In a judicial foreclosure, the lender sues the borrower in court. This process is required if the lender wants to obtain a deficiency judgment to hold the borrower liable for the unpaid balance of the debt. In a nonjudicial foreclosure, the lender issues a notice of default to the borrower and, after a waiting period of almost four months, may sell the property at auction (trustee's sale).

Nearly all foreclosures in California involve the nonjudicial process. Lenders using the nonjudicial foreclosure process are prohibited from seeking a deficiency judgment against the borrower (Sec. 580d of the California Code of Civil Procedure). As a result, the balance of the debt is canceled by operation of law.

Myth No. 2: Nonjudicial foreclosure converted the debt from recourse to nonrecourse.

If the lender used the nonjudicial foreclosure process, the debt was converted from recourse to nonrecourse.

Wrong: Several real estate attorneys have told me that this is a misinterpretation of Sec. 580d. This section prohibits a deficiency judgment if the lender used the nonjudicial foreclosure process. It doesn't convert the borrower's personal liability for the debt from recourse to nonrecourse.

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Myth No. 3: The debt was recourse because Form 1099-C says so.

A client gives you a Form 1099-C that has box 5 checked "Yes," indicating that the borrower was personally liable for the debt. This means that the debt was recourse.

Not necessarily: In almost all instances I have seen, the "Yes" box on this form has been checked--but you can't rely on the information on this form without verifying it with your client or from other sources.

Myth No. 4: There is no COD income because the FMV on Form 1099-C exceeds the debt.

A client gives you a Form 1099-C for a canceled recourse...