It likely is not taxable, but you'll need to respond to the letter. This settlement occurred because of the housing market crash in 2008, when many banks didn't follow best practices on foreclosure and had to pay these amounts to those who obtained mortgages through them. Those amounts were typically issued on 1099-MISC forms, but in box 3 which is not self-employment. But in this case it was likely not taxable. The reason was that you lost value on your home, and through the foreclosure, "sold" the home at a loss. Here is what the IRS instructs to do, direct from their website:
"Home Foreclosure and Debt Cancellation
3. I lost my home through foreclosure. Are there tax consequences?
There are two possible consequences you must consider:
- Taxable cancellation of debt income.(Note: As stated above, cancellation of debt income is not taxable in the case of non-recourse loans.)
- A reportable gain from the disposition of the home (because foreclosures are treated like sales for tax purposes).(Note: Often some or all of the gain from the sale of a personal residence qualifies for exclusion from income.)
Use the following steps to compute the income to be reported from a foreclosure:
Step 1 - Figuring Cancellation of Debt Income (Note: For non-recourse loans, skip this section. You have no income from cancellation of debt.)
1. Enter the total amount of the debt immediately prior to the foreclosure.___________
2. Enter the fair market value of the property from Form 1099-C, box 7. ___________
3. Subtract line 2 from line 1.If less than zero, enter zero.___________
The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
Step 2 – Figuring Gain from Foreclosure
4. Enter the fair market value of the property foreclosed.For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure ________
5. Enter your adjusted basis in the property.(Usually your purchase price plus the cost of any major improvements.) ____________
6. Subtract line 5 from line 4. If less than zero, enter zero.
The amount on line 6 is your gain from the foreclosure of your home. If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income. If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses."
In these instructions, you are concerned with step 4. You must add the payment you received to the amount of debt that was cancelled, and subtract the purchase price. If you have a gain, you then may exclude $250,000 of the gain from your taxable income from that year (up to $500,000 if you filed a joint return). It is VERY UNLIKELY that you would have gained that much from the payment.
What you will need to do is the math exercise in lines 4 through 6. Lines 1 through 3 do not apply to you because it is a home loan, a nonrecourse loan. Provide the information to the IRS, and you will likely not be paying any additional taxes.
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