Obviously this isn’t going to be the sunniest blog I’ve posted, but my hope is that readers can use the knowledge I’m sharing to empower themselves; an important step toward starting the financial and emotional recovery process.

The reality is that financially stressed homeowners can’t afford their homes and they can’t sell them which forces them into dramatically dropping their asking price, incurring a significant loss, or relinquishing their homes via foreclosure. Regardless of buying trends, in many cases, the home’s current market value isn’t even sufficient to cover the outstanding mortgage balance, causing lenders to write-off the amount of unpaid mortgage balance.

Here’s where things can go seriously wrong. Many individuals are completely unaware of the income tax consequences associated with distressed home ownership and may be shocked to find out they own thousands of dollars come tax season.

I know what you’re thinking, how is this possible? Well, here’s how it works: When a lender writes-off a loan balance (either partial or in whole), they are required to issue a Form 1099-C for the amount of the write-off to the borrower. This applies to any type of loan (auto, mortgage, credit card, etc.). Generally, the write-off amount is recognized as taxable income on the borrower’s tax return. For example, if a credit card company writes-off a $10,000 balance, then a Form 1099-C will be issued for the amount. Now let’s assume the borrower receiving the Form 1099-C is in the 15% tax bracket. The borrower will have an additional $1,500 in taxes due ($10,000 x 15%). So now, the borrower (who’s broke, mind you) has to come up with $1,500 to pay these taxes. Are you seeing the “catch 22” going on here? What is the borrower supposed to do, charge the tax on a credit card? If this situation is bad enough, imagine a mortgage write-off!

Fortunately the government isn’t a completely heartless entity, despite appearances. When foreclosures started to accelerate a couple of years ago, Congress enacted tax law changes to exclude from taxable income, debt write-offs associated with a taxpayer’s primary home. It is important to remember this ONLY applies to mortgages used to purchase or improve a primary home. It DOES NOT apply to other types of loans such as automobile loans, credit cards, and home loans NOT used to purchase or improve a primary residence. Unfortunately, these other loan write-offs will generally continue to be taxable income. However, there are some additional exceptions to inclusion of canceled debt as taxable income.

While there’s really just a glimmer of a silver lining here, for homeowners caught in this turbulent situation, any relief is welcome when it feels like their world has been turned upside down.

Although I’ve broken down the basic concept of one aspect of income tax exclusion for some cancelled debts, the many tax laws associated with any cancelled debt are very complicated. Distressed homeowners and others facing loan and credit card write-offs can save themselves more stress and unexpected tax bills by seeking competent advice from an accountant who will steer them clear of any further disasters.

Come back next week for part two when we’ll discuss another tax consequence related specifically to home foreclosures. In the mean time, feel free to leave your comments and let us know about your situation.

_{Fred Daus is the Chief Executive Officer and founder of Fredrick James Accounting, Tax & Consulting. He is a member of National Society of Accountants and the National Society of Tax Professionals and has been helping clients save money since 2001. Fredrick James is an innovative, full service accounting firm in Clearwater, Florida with a focus on providing outstanding service, tax savings and financial growth to clients in the Tampa Bay area and Nationwide. Visit our website www.FredrickJames.com or call 727-230-0716 for more information.}

_{U.S. Treasury Department Circular 230 Disclosure: In accordance with applicable professional regulations, please understand that, unless specifically stated otherwise, any written advice contained in, forwarded with, or attached to this communication is not a tax opinion and is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue code. The information provided on this blog is not intended to provide or be a substitute for specific individualized accounting, tax, legal, business, or investment planning advice. Where specific advice is necessary or appropriate, Fredrick James, LLC recommends consultation with a qualified Accountant, Tax Advisor, Lawyer, Financial Planner or Investment Manager. The information provided herein is for general informational purposes only and should not be considered an individualized recommendation, personalized investment advice or an endorsement by Fredrick James, LLC. The information presented is prepared for a general overview of subject matter; however, its accuracy, completeness or reliability cannot be guaranteed and therefore should not be relied upon as such. Fredrick James, LLC accepts no liability for any direct or consequential loss arising from any use of this information.}