Some borrowers believe that foreclosure may allow them to circumvent tax liability, but release of debt may occur following completion of a foreclosure. In addition, this may happen without the borrower even knowing it, until they receive the 1099-C from the lender. Again, the borrower has no ability to request the lender not issue the 1099-C, and if the lender chooses to release the debt following the foreclosure action, either on its own accord or in response to post-deficiency negotiations, the debt forgiven will likely be much larger and the incidental tax liability much greater due to the additional costs and fees that accumulate and grow on the balance of a loan throughout a foreclosure action.
Borrowers also believe bankruptcy to be a potential solution to tax liability. This may be accurate depending upon when the borrower files bankruptcy. Income tax liability is not typically dischargeable particularly if the forgiveness of debt occurs prior to the bankruptcy filing.
Tax consequences resulting from short sales, debt settlement, loan modifications, and foreclosures are fact specific and should always be evaluated by a professional. In many cases, tax planning can help a seller legally avoid or minimize the tax consequences of their transaction. If the seller proceeds without planning for the tax impact of the transaction, they are often unpleasantly surprised with the outcome.