Some days I wonder if the whole financial market has simply gone mad. Here’s the latest challenge for people who walked away from property through foreclosure, short sales, etc..
First of all, there was the nasty surprise that started hitting people earlier in 2010 when they realized that by walking away from upside down property, they could owe taxes.
That came when a property had a debt on it that was more than it was worth. If there was a foreclosure, the lender would first issue a Form 1099-A and then, once the debt was canceled, issue a Form 1099-C.
The Form 1099-C means there is Cancellation of Debt income. This COD income may or may not be taxable. If it was your principal residence, then you’ll probably get a pass on paying tax. But, don’t count on your state to follow the fed’s lead on this. You still might owe state income tax on the COD income for your principal residence.
But if the property was a real estate investment property, you don’t get a reprieve. You owe taxes on the COD income. There is a possible strategy here, though, if you lost money on the property. In other words, the debt is close to what you paid or even less than you did. In that case, you’ll have a loss on the transaction that can offset the COD income. But, you’re stuck if you did cash-out refi’s that increased the loan, but not the basis.
If you’re insolvent or declare bankruptcy, the IRS doesn’t make you pay the tax, but again, not all states have followed suit on this.
Now, there is a brand new problem. It’s called Zombie Credit Collectors.
When I first heard this term last week, I thought of “Night of the Living Dead” and couldn’t figure out what on earth it referred to. But no, the collection agency workers aren’t zombies. It’s the debt that’s dead.
Apparently, some of the big banks have started selling off their bad debt. But their records aren’t really good. They are selling anything that has late payments and isn’t currently paying, without checking whether the debt was later paid off or cancelled.
And the credit collection agencies are vigorously pursuing action on the debt that really isn’t debt anymore.
The agencies are going on records they believe are accurate. The banks are returning phone calls. And the former owners are now stuck with debt that has been canceled (and that they have likely paid tax on) now suddenly being due again.
In the past week, I heard from 4 people in this spot. And from a few reports I’ve heard from other accountants, it’s happening all over the country. Look for this to be the next big issue for real estate.