After Foreclosure, a Big Tax Bill
From the I.R.S.
By GERALDINE FABRIKANT
Published: August 20, 2007
Two years ago, William Stout lost his home in
Allentown, Pa., to foreclosure when he could no
longer make the payments on his $106,000 mortgage.
Wells Fargo offered the two-bedroom house for sale
courthouse steps. No bidders came forward. So Wells
Fargo bought it for $1, county records show.
Despite the setback, Mr. Stout was relieved that his
debt was wiped clean and he could make a new start.
He married and moved in with his wife, Denise.
But on July 9, they received a bill from the
Internal Revenue Service for $34,603 in back taxes.
The letter explained that the debt canceled by Wells
Fargo upon foreclosure was subject to income taxes,
as well as penalties and late fees. The couple had a
month to challenge the charges.
For those who struggle to pay their bills, who watch
their housing payments rise out of reach with their
adjustable-rate mortgages, who lose a job or who
fall victim to illness, losing one’s home can feel
like hitting bottom. But one more financial
indignity may await as the fallout from the great
housing boom ripples across the United States.
“Getting that tax bill,” Mrs. Stout recalled, “my
first thought was that I needed to see my family
doctor to help me with my stress, because we had a
big mortgage and other debt and then here came the
I.R.S. saying we owe this.”
Notices of unpaid taxes, unanticipated and little
understood, will probably multiply as more people
fall behind on their mortgages, said Ellen Harnick,
senior policy counsel at the Center for Responsible
Lending, a nonpartisan research and policy center in
Foreclosure is one way that beleaguered homeowners
can fall into this tax trap. The other is when
homeowners are forced to sell their homes for less
than the value of the mortgage. If the lender
forgives that difference, they are liable for income
taxes on that amount.
The 1099 shortfall, as it is called, stems from an
Internal Revenue Service policy that treats forgiven
debt of all types as income even if the taxpayer has
nothing tangible to show for it, unless the debt is
canceled through bankruptcy.
The Center for Responsible Lending expects that 20
percent of the home loans made in 2005 and 2006 to
people with weak credit, commonly called subprime
loans, will end in foreclosure. Because so little
money was required as a down payment during the
boom, the value of many of these houses may be less
than what is owed.
Some people in this predicament are fighting the
I.R.S. and winning. Sometimes, lower payments can be
negotiated with the I.R.S., tax experts say.
In other cases, bankruptcy or a claim of insolvency
can eliminate the tax burden. Sometimes, the bills
are sent out erroneously, as banks fail to keep
track of home values and what price the properties
ultimately sell for.
“The tax laws are far too complex for borrowers to
understand,” said Kurt Eggert, a professor at
Chapman University School of Law, noting that there
are distinctions between selling a house for less
loan amount and losing one in foreclosure. He says
it is crucial to get expert tax advice to sort
through the bewildering complications.
The whole concept can be counterintuitive. “Your
home has declined in value and you lose it,” Mr.
Eggert said. “Then the I.R.S. says you owe tens of
thousands in taxes because you got a windfall when
the debt was forgiven.”
Mr. Stout has suffered doubly from the downturn in
the housing market. He earned $65,000 last year as a
salesman for a roofing company. But last winter, his
job was cut from a salaried position to an hourly
one. Then his hours were reduced, as construction
demand eased. Through July he had earned only
$25,000, said his lawyer, Stephen G. Doherty, of
Bennett & Doherty in Doylestown, Pa., putting him on
pace for a pay cut over all this year.
Mr. Doherty set out to appeal the Stouts’ tax bill
by arguing that Wells Fargo got the home as
collateral so the family did not reap a benefit. The
Stouts and their lawyer also hoped to show that
Wells Fargo was able to sell the house for far more
than $1. Finally, they contended that penalties were
inappropriate because they did not receive a tax
notice in 2005 or 2006.
After a reporter inquired about the Stout matter,
Wells Fargo Home Mortgage said last week that it had
reviewed the Stouts’ tax documents and was filing a
corrected 1099 tax form to show that no debt had
been canceled, because the fair market value of the
home was actually more than Mr. Stout had owed.
Mr. Doherty, the Stouts’ lawyer, pointed out that
the acquiring lender, in this case Wells Fargo, has
some leeway in valuing a house. The fair market
value can be the high bid at a sheriff’s sale, or an
In this case, Wells Fargo’s about-face was tied to
an appraisal that Mr. Doherty says he believes was
completed before the sale. It set the value of the
house at $132,844, eliminating the Stouts’
liability. (Lenders do periodic appraisals once a
property is in default, Mr. Doherty said.)
The Stouts found in county records that Wells Fargo
had sold the house to U.S. Bank for $106,000 — the
same amount Mr. Stout had owed — in March 2006. The
house was resold that month for $140,000.
An I.R.S. spokesman would not comment on the Stout
matter or how the agency applies the tax rules on
forgiven debt, but referred to a document on the
Diane Thompson, a lawyer in Godfrey, Ill., for the
National Consumer Law Center, says the tax can be a
real hardship for some people.
She recalled a client who owed $39,000 to her lender
and got a tax bill after her house was sold in
foreclosure for $10,000. Ms. Thompson appealed to
tax authorities, contending that her client, a
part-time waitress, was broke because her debts were
greater than her assets.
“If you can prove you are insolvent, the I.R.S. does
not treat the forgiveness of debt as income,” Ms.
Thompson said. Her client did not have to pay.
Lawyers may also be able to show that the original
loan process was so flawed that the borrower is not
liable for taxes. Indeed, during the real estate
bubble, lenders and mortgage brokers sometimes
encouraged homeowners to borrow more based on
inflated home values.
Such was the case with Agnes Mouser, a 65-year-old
widow who works in the records department in a
Houston prison. In 2000, she sought to pay off her
credit-card debt with a loan from Beneficial
which sent an appraiser to assess the value of her
“A real nice young man came out to see me,” Mrs.
Mouser recalled. “He could have been my grandson.”
That appraiser compared her 1977 mobile home with
two new standard homes with two-car garages. Using
those homes as benchmarks, Beneficial agreed to lend
$34,730 on her home, valued at $43,500, in
2000. Mrs. Mouser’s loan carried an interest rate of
14.88 percent, and she paid 7 points, or $2,431, at
closing to get that rate, along with $270 to
Beneficial for the appraisal.
A spokeswoman for HSBC, the parent company of
Beneficial, said it did not comment on matters
involving specific customers.
In 2003, when Mrs. Mouser could not meet the
payments, she contacted Ira D. Joffe, a lawyer in
Houston. He found that her property was valued by
the county at $19,970, less than half of what
Beneficial had estimated.
“I promised to depose the appraiser’s Seeing Eye dog
if there was a lawsuit,” Mr. Joffe recalled telling
Beneficial released the lien. But then Mrs. Mouser
got a tax bill for $10,000, or the amount owed on
the $29,566 that Beneficial had treated as a
“The tax bill scared her to death,” Mr. Joffe
recalled. “It took a letter from an accountant and
two letters from me to get the I.R.S. to go away.”