Congress Extends the Income Exclusion for 1099 ‘Forgiven’ Mortgage Debt to Tax Years 2015 and 2016

For a more detailed discussion on tax debt and other tax resolution issues, be sure to read Wartchow Law’s Tax Blog.

On December 18, 2015, Congress extended certain tax breaks to apply for both tax years 2015 and 2016, including the income exclusion for forgiven mortgage debt on a qualified principal residence. “Forgiven” or “cancelled” mortgage debt on a Form 1099-C occurs usually after a homestead is foreclosed, short sold or otherwise a defaulted mortgage goes unpaid for the statutory period of time. Upon the occurrence of these events, banks are required to treat the unpaid balance as “forgiven” and issue a Form 1099-C to the homeowner for the balance that is cancelled. (The term “forgiven” is a gross misnomer since, in fact, the mortgage balance remains lawfully collectible in full—more on that later in this article).

As of October 20, 2015, the Mortgage Debt Relief Act had not yet been extended to tax year 2015. However since President Obama approved an extension of the tax relief for the next two tax years (i.e., 2015 and 2016), this means that homeowners receiving a 1099 for mortgage debt will not be required to declare mortgage debt as taxable income on their federal income tax return. In past years, Congress has typically waited until December to extend the Act’s tax relief to homeowners (better last minute than never).

The Internal Revenue Service and state taxing authorities treat the 1099’d mortgage debt as taxable income unless an exclusion is claimed by the taxpayer on Form 982 for the tax year for which the 1099 is issued. This means that a 1099 received on even a mortgage balance of $30,000, for example, can result in significant federal and state income tax liability upwards of $5,000 or more for just a middle-income taxpayer. For higher income earners, this 1099 could result in massive tax consequences into the tens of thousands. The exclusion operates to exclude the 1099 from taxable income if the amount forgiven was “qualified principal residence indebtedness”. For current information on this and other income exclusions, see IRS Publication 4681.

This income tax exclusion for forgiven mortgage debt dates back to 2007 and Congress’s then-response to overwhelming consumer need for protection against tax liability contained in the Mortgage Foreclosure Debt Forgiveness Act. This most recent bill passing by Congress now allows for homeowners to claim the income exclusion on their 2015 and 2016 tax returns (assuming the 1099-C is issued for 2015 or 2016).

Tax year 2017 is currently without any extension of the mortgage debt income exclusion–look for that decision to be before Congress in December 2017. Other income exclusions may still be available however, for example the insolvency exclusion or the exclusion for a discharge received in bankruptcy.

This income tax “relief” for forgiven mortgage debt is not to be taken without a heaping measure of caution, however.

First, a 1099 does not actually denote that the mortgage balance forgiven and, in fact, the homeowner still owes the entire amount to the bank which can be collected upon via lawsuit and other means. Wait, back that up. The bank declares the mortgage forgiven and takes their tax benefit, the homeowner is personally responsible for the resulting income tax on the forgiven amount, but yet the homeowner can STILL be held accountable for the mortgage balance owed? Yes, actually. Practically, this means that the bank may still lawfully report the entire balance as due, owing and in default on a homeowner’s credit report, potentially ruining their credit. More significantly, perhaps, this also means that a homeowner can be sued for the forgiven balance and, if judgment is obtained, their wages garnished and bank account levied.

There are many state courts around the country—including here in Minnesota—that have declared that issuance of a Form 1099-C does not alone operate to legally extinguish a debt and, therefore, the full balance remains outstanding absent some operation of the law, such as a discharge received in a bankruptcy proceeding. These courts rely on an IRS Information Letter dated December 30, 2005, which explained: “The Internal Revenue Service does not view a Form 1099-C as an admission by the creditor that it has discharged the debt and can no longer pursue collection.” See I.R.S. Info. 2005-0207, 2005 WL 3561135 (Dec. 30, 2005). How’s that for deceptive wording?

Second, the timing of asserting the exclusion on your income tax return is tight to say the least. Assuming a homeowner timely receives the 1099-C following the end of the tax year for which it is issued, they still have time to report the income and claim the exclusion via IRS Form 982. But for homeowners who did not timely receive the 1099-C from the bank, the deadline to amend their tax return to claim the exclusion is six months from the date the return was originally due, which is usually April 15th of the following year. As an illustration, if a homeowner was in an active bankruptcy proceeding when the bank declared the mortgage forgiven on a home foreclosed prior to filing bankruptcy, the bank may have issued a 1099-C to the IRS yet simply never sent the 1099-C to the homeowner due to their being in bankruptcy at the time (or instead of bankruptcy, perhaps the 1099 was lost in the mail or the bank sent it to the wrong address). In this example, the homeowner may not find out about the 1099-C until years later when the IRS sends a collection letter for the additional income tax due on the forgiven mortgage—and all in spite of the bankruptcy. The result is that the homeowner is outside of the 6-month deadline for amending their 2013 tax returns to claim the income exclusion and is now strapped with the additional tax debt and a battle against both the bank and the Internal Revenue Service. Try unwinding that tax debacle.

For more about 1099s and the insolvency exclusion, see Received a Form 1099-C on Foreclosed Home? You May Qualify for the Mortgage Forgiveness Exclusion to Cancellation of Debt Income.

The Student Loan “Debt Bomb”: With Student Loan Debt Out of Control, What Can Bankruptcy (and Congress) Do to Help?

A new financial catastrophe is facing Americans, and it’s quickly becoming America’s latest and greatest “debt bomb”. According to the National Association of Consumer Bankruptcy Attorneys in August 2014, there are 7 million Americans in default on over $100 million in student loan debt, and the total student loan debt carried by Americans (defaulted and non-defaulted) is an enormous $1.2 trillion. To put this confounding figure into context, $1.2 trillion dollars is equivalent to 1,200 billion dollars, or over a million million dollars. $1.2 trillion is enough to buy a new Prius for about half of all American households, or to pay Congress’s salaries for over 11,000 years.

To measure the extent of the student loan crisis on Americans, simply compare this $1.2 trillion in federal and private student loan debt to the total $1.3 trillion in toxic subprime mortgages that coincided with America’s most recent recession. The foreclosure crisis of the 2000s has now (and almost dollar-for-dollar) been replaced by this decade’s student loan crisis.

Currently there is nearly nothing that filing bankruptcy will do to cauterize the student loan crisis. But a wave of change is on the horizon.

As recently as ten years ago and prior to the 2005 amendments to the Bankruptcy Code, most private student loan debt was dischargeable in a bankruptcy proceeding.  However for the past ten years, debtors have found no relief for their student loan debt in bankruptcy: bankruptcy will not even discharge late fees or reversed-amortized interest due on accrued interest, which can have the effect of doubling the amount due on a defaulted student loan. In a penalizing twist of fate, chapter 13 debtors can emerge from a 5-year chapter 13 plan actually owing as much as twice more on their student loans than when they first filed chapter 13.

U.S. Congress is presently considering reform to higher education legislation, including possible relief for private student loan* debt in bankruptcy.  The suggested student loan bankruptcy reforms include fast-track discharge for private student loans in cases of death or permanent disability, discharge where the private lender has failed to offer the borrower deferment and forbearance options, discharge of private student loans that carry unreasonably high interest rates, and discharge of both federal and private student loans which are granted from institutions having high drop out and default rates (i.e., many for-profit institutions that target low-income students and where success is measured by profit rather than graduation rates).

To date, Congress has done nothing to meaningfully address bankruptcy reform as the student loan crisis continues to drive generations of Americans into widespread default with no avenue for even a moderate relief in the form of restructure of student loan interest rates, late fees or accrued interest.

*Private student loans are not funded by the federal government, which means these loans are obtained directly from banks, credit unions, schools and other market lenders at usually higher interest rates that compare to credit cards. Unlike federal loans, private student loans cannot be consolidated, often require a co-signer and may require payments due while the student is still in school.  Critically unlike federal loans, private student loans may not offer forbearance or deferment in situations of medical or financial hardship.

Wartchow Law Office provides free bankruptcy consultations to discuss options in Chapter 7 and Chapter 13 consumer bankruptcy as well as non-bankruptcy debt relief alternatives.