The IRS says there is no free lunch. If you transfer title on your home, whether voluntarily through a warranty or grant deed, or involuntarily through foreclosure, you have SOLD your home. You might be subject to taxes, even if you sold your home at a loss, either on a short sale or by foreclosure.It doesn’t seem fair. What’s worse is you might not even find out that you owe taxes until the day you open your mail to find a 1099. Source: Elizabeth Weintraub
For example: Assume a family purchased their home for $200,000, with a mortgage of $195,000. Later, they need to sell the home, and find that the value of homes in their area has declined, and they can sell for only $185,000. At the time of the sale, the outstanding balance on the mortgage might be, for example, $190,000. Thus, there will not be enough cash at settlement to repay the lender the full balance of the mortgage. In some circumstances, a lender might forgive the amount of any shortfall ($5,000 in this example).
In this example, the seller will be required to recognize $5000 of income (the forgiven amount of the debt) and pay tax on it at ordinary rates. Thus, the seller, who has experienced a true economic loss, is required to pay tax on any phantom income, even though no cash has changed hands and even though he has experienced a loss. Similar results would apply in a foreclosure where some debt amount remains outstanding at the conclusion of the proceeding.
Any lender who forgives debt is required to provide a Form 1099 information report to the borrower and to the IRS stating the amount of the forgiven debt. The Form 1099 will be required in any circumstance when a debt is forgiven, whether it is a short sale, foreclosure, deed in lieu of foreclosure or any similar arrangement that relieves the borrower of the obligation to pay some portion of a debt. More information about Foreclosures, Short Sales and Taxes