Foreclosed your house? That's income

GRAND RAPIDS, Mich. (WOOD) -  Imagine losing your home to foreclosure and then getting socked with a big tax bill.

People who had their home foreclosed or sold as a "short sale" last year, could get an unpleasant surprise from their mortgage company.

Accountants are expecting a huge number of taxpayers to be hit with the 1099-C form. It looks just like a W-2 form and it means pretty much the same thing -- except the C stands for Cancellation of Debt in the eyes of the IRS.

The bank's loss on your mortgage is considered income that you have to pay income tax on.

Accountants are expecting a huge number of taxpayers to be hit with this form. Mortgage companies have to mail it to you by January 31, and the tax will be due, of course, April 15.

Last year in the Grand Rapids metro area, local realtors say 51% of all home sales were foreclosures, so those distressed homeowners should be getting the 1099-C.

The 1099-C has been around for years, but tax payers are unfamiliar with it because they usually don't have too many events that warrant it.

Grand Valley State University CPA Doug Vander Aa said, "When you borrowed that money from the bank you got it tax free, $150 - 200,000, on the understanding that you would pay it back. That was a loan. When the bank forecloses and walks away from part of that debt, the IRS still keeps track of that debt and say, 'Oh, you have $500,000 you never paid tax on. That's income.'"

There are three exceptions you can take to avoid the tax.

• Number one, if you are in bankruptcy.
• Number two, if you are technically insolvent. You add up all your assets and your liabilities and you can prove you owe more than you own. This can be very tricky, but your assets will include everything from your retirement savings to the cars you own.
• There is a third exception that Congress recently passed, and it will probably apply to most cases. You are exempt from the tax if the cancellation of debt applies to your principal residence and you used the money to buy, build or improve your home.

This exemption, however can be tricky, because it may not work if you took out a home equity loan to pay for other things.

"So if you took your accountants advice, instead of taking a $20,000 car loan or loan to pay for college, if they took this advice, get it and you can write off the interest. Then that portion of the loan is not eligible for the exclusion," Vander Aa said.

You also have to have lived in the house for two of the last five years. Tax advisors say if you're not sure about any of this, this may be a very good time to find the cash and hire a professional, even if money is tight - because if you lose, and didn't pay, you face interest and penalty. And that's very difficult to avoid.

Inside woodtv.com:

IRS Cancellation of Debt form (pdf)

On the Net:

IRS Instructions Form 1099