Financial Nightmare Doesn't End With Foreclosure: There's the IRS

By Christopher Maag

Christine, a Credit.com reader, thought that after losing her home to foreclosure, there would be no new financial shocks for a while.

Then she received a letter from the IRS.

"I filed my taxes in 2010 and thought everything was fine," Christine wrote in a comment to a Credit.com story, "then yesterday I received a letter from the IRS stating that I received a 1099-C for 2010 on a house that I lived in that was foreclosed on."

The 1099-C is quickly becoming the shadow nightmare of the foreclosure crisis. It is a form from the Internal Revenue Service. The idea is this: If a consumer gets a debt canceled, forgiven or discharged, it's akin to receiving unexpected income. That windfall -- the full amount of canceled debt -- gets added to the consumer's gross income.

And just like any other type of income, it gets taxed.

"Suddenly, you've got a potential tax nightmare," say Gerri Detweiler, Credit.com's consumer credit expert.

Christine thinks there must be some kind of mistake. She lost her house to foreclosure, so she shouldn't have to pay any extra taxes on it, right?

"What forms do I fill out to send to the IRS to show that I was foreclosed on?" she asks.

Here's the problem for Christine and other taxpayers in her position: The IRS already knows you were foreclosed upon. That's precisely why they're sending you a bill.

"The fact that you were foreclosed upon doesn't mean you automatically don't have to pay taxes on the canceled debt," Detweiler says. "Instead, you have to demonstrate that you qualify for an exclusion or exception."

If you've recently received a 1099-C or its sister form, the 1099-A, here are some tips for what to do next:

1. Don't ignore it.

If you've received a 1099-C form in the mail, that means your creditor has informed the IRS about your canceled debt. Failing to respond, either by paying the taxes or applying for an exception, could cost you lots more money, Detweiler says.

2. Get professional help.

The 1099-C is notoriously complicated. Unless you're a tax expert yourself, don't try to tackle it alone. "If you are accustomed to doing your own taxes, this is one situation where it can really pay to get expert advice from a tax professional who has experience with this particular issue," Detweiler says.

3. Apply for an exception or exclusion from the tax.

The tool for this is IRS Form 982. Again, do not attempt this by yourself, Detweiler warns. "Form 982 is extremely complex, and very few taxpayers or preparers are familiar with it," says Nina Olsen, the National Taxpayer Advocate.

4. Know what to expect.

The most common way to avoid paying taxes on a foreclosure is Chapter 11 bankruptcy or insolvency. Here's an example of insolvency: Your assets are worth $45,000 and your debts total $55,000, which means you are $10,000 insolvent. If your creditor agrees to forgive less than $10,000 of your debt, therefore, $8,500, you are not required to report any of that money as income on your taxes

But be aware: You still have to submit Form 982 to prove that the canceled debt should be excluded.

5. Read more.

Gerri Detweiler has responded to the deluge of reader questions about the 1099-C mess with a series of helpful stories and infographics on how to respond if you get one of these dreaded forms in the mail. Her infographic is here. Her stories are here, here, here and here.

See more at Credit.com:
5 Red Flags of the Next Mortgage Crisis
How to Give a Short Sale Your Best Thought
Underwater Homeowners Ask: Should I Stay or Should I Go?

More on AOL Real Estate:
Find out how to calculate mortgage payments.
Find homes for sale in your area.
Find foreclosures in your area.
Find homes for rent in your area.

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