Thursday, April 7, 2011

Bankruptcy and the Tax Ramifications of Debt Forgiveness

       Mr. and Mrs. X faced a major setback. Mrs. X lost her job in this terrible economy and the unemployment checks just were not enough with her husband's income to meet all of their debt obligations.  With the home mortgage, real estate taxes, insurance, credit cards, taking care of the bills generated by the kids, medical bills - it was just too much.  The X family tried to obtain a loan modification and the bank would not work with them.  Eventually, the bank foreclosed on their home and they are now renters in an apartment building.   Mr. and Mrs. X are afraid the bank might pursue them for the difference between what the bank obtained at the foreclosure sale and the balance the X family owed on the mortgage. The credit card companies are now suing Mr. and Mrs. X for the unpaid balances. 
       Mr. and Mrs. X cannot tolerate the dunning calls from the collection agencies.  The world feels like it is crashing down around them.  Stress!  Mr. and Mrs. X cannot face the mountain of debt and have  filed a Chapter 7 petition in bankruptcy.  The bankruptcy case went smoothly, the debt was discharged and they are ready to start over in a matter of months.  The Chapter 7 bankruptcy gave them the fresh start they needed - they emerged from bankruptcy with their credit card debt discharged and no deficiency claim owed to their mortgagee bank.
       April 15 is rapidly approaching and Mr. and Mrs. X need to file their tax returns.
       The bank sent Mr. and Mrs. X a form entitled "1099-C" which listed the amount of debt forgiven by the bank on account of the foreclosure sale. Mr. and Mrs. X need to make sure two things are correct on this form i.e. (1) the value of their home when it was foreclosed and (2) the balance of the debt, namely the $amount of debt forgiven.  If they dispute either, they need to contact the bank ASAP.
       From a tax perspective, Mr. and Mrs. X are now worried they may face paying taxes on the debt forgiveness the bankruptcy code gave them by discharging their credit card debt, and the debt forgiven on the mortgage balance.
       Mr. and Mrs. X probably have nothing to worry about as the credit card debt and the amount of debt forgiven on their home due to the discharge received in the bankruptcy case should not be a taxable event for them under current law.  However, I am not an accountant and Mr. and Mrs. X should check with either an accountant or tax attorney. 
       The following points of information may be helpful in seeking answers to their tax questions, remembering that laws and rules and forms change so while the information may be current today, please be sure and determine if the information below has been updated or changed when your needs arise:

       First, start with the words of the Bankruptcy Code at Section 346, focusing on subsection j. (The Cornell Law School web site provides great free researching to the general public.) See 11 U.S.C. § 346,

       And, here are the Legislative Notes on Section 346, which may help you better understand this Code Section,

       Second, take a look at Section 108 of the Internal Revenue Code.  See 26 USC § 108,

       Third, although debt discharged in bankruptcy may not be a taxable event to you, it may be a reportable event to the IRS, take a look at the Code of Federal Regulations.  See  26 C.F.R. 1.6059p-1(a)(3),
And, take a look at IRS Form 982 regarding reporting:

       Fourth, take a look at the information provided by the IRS.  This is the Bankruptcy Tax Guide issued by the IRS in March of 2009 (always check the IRS site for more updated publications):

       Fifth, is IRS Publication 4681 on cancelled debt (which should be updated shortly, keep going to the IRS site for more updated information):

       Finally, this is the Mortgage Cancellation Debt Relief Act and Debt Cancellation information from the IRS web site:

April 15 is rapidly approaching, so good luck with your filing!