After completing a short-sale, it is common for the seller to receive a Form 1099-C from the lender or lenders who received less than the balance owed on their secured notes. The form will show the amount of debt cancellation from the transaction, which may result in taxable income to the seller/borrower.
While it is normally preferable to pay tax on the debt canceled rather than be forced to actually pay the debt, the two are not always mutually exclusive when it comes to the issuance of a 1099-C. In other words it may be possible for a lender to issue a 1099-C for cancellation of debt resulting from a short-sale, while still pursuing the borrower for the deficiency.
The problem lies with the IRS regulations directing the lender when it should issue a Form 1099-C. While in most instances the lender cancels the debt, then issues a Form 1099-C by the following January to the debtor. However the regulations may require the issuance of a 1099-C if a payment has not been received during a testing period and certain other conditions are met. The current testing period is 36 months, but that could change in the future.
If the borrower includes the 1099-C amount in his income, then is forced to pay the debt at a later date, the statute of limitations may have expired to amend the return and receive a refund of the related tax.
Borrowers who have received a 1099-C, but have no additional agreements binding the lender’s ability to collect on the note, should consult with an attorney in order to determine if the lender has a reservation of rights or other legal means to collect on the note. Arizona has case law relating to this issue as do other states, but there is no simple rubric to follow in determining the outcome of this issue in Arizona.
I would hope that future 1099-C forms will include language stating whether the lender is legally discharging the debt or merely issuing the form based on IRS regulations and thus reserving the right to enforce collection of the obligation.
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