Not many consumers know that the IRS treats forgiveness of debt as income. That means that a borrower whose lender “forgives” the debt – completely waives the debt or accepts less than the full amount, is taxed on the savings, and reported to the IRS on Form 1099-C. This occurs with mortgages as well as other debts, except that the amounts involved are larger. While commonly seen with credit cards for many years, in 2017 homeowners will now feel the sting.

The forgiveness of debt rule applies to mortgages as well. So, if a mortgage holder forgives part of the debt, either by principal reduction, short sale or foreclosure, the owner gets the 1099-C for the lender’s loss. An example, in foreclosure, a $400,000 mortgage sold at auction with a fair market credit of $250,000, leaves the homeowner with $150,000 in income to be taxed at his/her top rate for federal and NJ income tax, which is frequently over 33%, resulting in a $50,000 tax. And the homeowner has lost the home.

The Mortgage Debt Relief Act granted relief from 1099-C income for the home for the years up to 2016, but it expired on January 1, 2017, so folks will be expected to pay up the taxes on the lender’s losses.

The best protection against this is by having the forgiveness to occur through a Bankruptcy, which is exempt from taxation, both for the home and any other forgiveness (credit cards, etc). Anyone facing the situation where lender will either grant relief or foreclose are well advised to talk to a their tax advisor and a competent bankruptcy lawyer about their particular situation.