It’s that time again. Time to explain why filing personal bankruptcy can provide enormous tax savings. Every year, several of our bankruptcy clients contact us in January or February because they have received a 1099-C form filed with the IRS by one of their former creditors. In case you don’t know, debts that are “canceled” or “forgiven” by a creditor may in some cases be treated as though you received that amount as taxable income under IRS rules. While this may seem inherently unfair to the ordinary person who receives a 1099-C—after all, she didn’t actually receive any income—the law can in many circumstances nevertheless treat the benefit she received by not having to pay that “canceled” debt as though it were taxable income.
By far the best protection from 1099-C liability, and the one I want to discuss here, is filing personal bankruptcy. If the reason that a given debt was “canceled” was because it was actually discharged in bankruptcy, then that debt is entirely excluded from one’s income, and there is no tax liability for such discharged debt. This is just one more reason why private debt settlement programs can’t offer the kind of debt relief that bankruptcy can. This is a huge relief to bankruptcy clients who are understandably shocked to receive a 1099-C from their former credit card company, or home equity line lender, or other commercial creditor. Imagine, receiving one of these listing $100,000 plus of debt you know was discharged in your bankruptcy case but now thinking that you might owe taxes on that discharged debt! Fortunately, we can quickly assuage our clients’ fears by explaining that, no, they will not owe any taxes on the debts that were discharged in their bankruptcy.
Unfortunately, it seems, many less well-versed tax preparers seem oblivious to the exclusion of debt discharged in bankruptcy from tax liability. So, even though we are bankruptcy attorneys, we have to put on our tax hats for a moment, and advise our client or former client to direct their tax preparer to IRS Publication 4681, which explains the bankruptcy exclusion for discharged debts along with other exceptions from liability on canceled debt. If the tax preparer knows what she is doing, she will prepare an IRS Form 982 to appropriately claim the exclusion for debts discharged under “Title 11,” which by the way is the Bankruptcy Code. Why the IRS can’t make this more clear for ordinary people by simply referring to the “Bankruptcy Code” on their form is beyond me, but I guess that would be too easy. If the client’s tax preparer is unaware of Form 982, I generally tell them it’s time to find a new tax preparer.
However—and this is really important—for the bankruptcy exclusion to apply, the debt must have been discharged by order of the Bankruptcy Court or by a plan approved by the court. This little pitfall can mean disaster, for example, if a lender on a recourse second mortgage, such as a home equity line, “forgives” or “cancels” the debt prior to the filing of the homeowner’s Chapter 7 or Chapter 13 bankruptcy case. For example, a short sale completed where there is a home equity line prior to bankruptcy may be the worst course of action from a tax perspective. This is yet another reason why it is so critical that if you are facing financial hardship, you should consult with an experienced bankruptcy attorney as early as possible.
There are other exceptions to 1099-C tax liability for sure. For one, the Mortgage Debt Relief Act of 2007 provided that homeowners could exclude from their income debt forgiven on their principal residence through 2012, but that law offered no help for recourse loans on second homes or for other types of debt. In California, most first mortgages even on second homes are treated as non-recourse loans, so they likewise don’t trigger any tax liability post-foreclosure. Additionally, the “insolvency” exception, may also be claimed on Form 982 without having filed a bankruptcy. However, the IRS definition of “insolvency” is substantially different than in bankruptcy because one’s retirement savings in accounts like 401(k)s and IRAs must be included in one’s net worth, while they may be entirely exempted in a bankruptcy case.
The bottom line is that personal bankruptcy filed before a given debt is “canceled” by a lender is the best protection against the IRS treating that canceled debt as though it were income and thus being taxed on it.