For most of us, finding out that we are getting a sizable tax refund is great news.

But if you’ve recently filed a Chapter 7 bankruptcy, hold your celebration.

That refund may not be yours.

You have a bankruptcy estate

When you file bankruptcy, all of your assets become a “bankruptcy estate”.  The estate includes your real estate; tangible things like cars and household goods; bank accounts; and legal rights.

Those legal rights might include the right to file a lawsuit;  your share of a class action suit; an interest in the estate of someone who has died; or your right to get back money you overpaid in taxes.

It’s not possession of the asset on the day your bankruptcy case that counts.  It’s whether the facts that entitle you to money have taken place.

So the refund is part of the estate even if you don’t receive it for months after your bankruptcy case is filed.

Tax refunds for closed tax years

If the tax year has ended when you file a bankruptcy case, any refund that follows from filing the tax return is property of the bankruptcy estate.

You may be able to claim an exemption in the refund.  An exemption removes the exempt asset from the estate and thus from the control of the bankruptcy trustee.

You get to keep your exempt assets.

If there are no exemptions available to protect the refund, the trustee will likely demand the turnover of the money.

When you file mid year

A tax refund for the year in which you filed your bankruptcy case is a bit different.  Only a fraction of the tax year ran before you filed.

Most trustees want the turnover of a fraction of the tax refund when you actually receive it.  If you file your bankruptcy case on April 1, 2017, one quarter of the 2017 tax year has run.

The trustee will want one quarter of your refund.

Do some simple tax planning

Let’s start with the mid year bankruptcy filing, where a fraction of the current year’s tax refund will be forfeit to the bankruptcy trustee.

You can fix that: see that there is no tax refund next spring.

Reduce your withholding after the bankruptcy is filed to eliminate the refund. You don’t have to continue to overpay.

A tax refund, after all, is just tangible evidence that you are paying too much tax each paycheck.  It may seem like found money when the refund check arrives, but it’s really just a loan you make to the government.  And you’re earning no interest on the loan.

File after refund spent

If you haven’t filed a bankruptcy case yet, consider waiting until after you have received the refund.

Once it’s paid to you, the refund is just money, money that you can spend on things that are either necessary or are exempt.

My favorite use of a pre filing refund is to fund your contributions to this year’s IRA.  Most people who need bankruptcy relief also need to get serious about retirement savings, too.

The only limits on what you can do with a refund you get before you file are the same as the rules about other transfers:  you can’t give money or things away to frustrate your creditors.

Or, as any experienced bankruptcy lawyer will tell you, you can use your refund to pay for the bankruptcy case.

The sooner you get out of debt, the sooner your financial life starts to make sense.

Image courtesy of Flickr and Great Beyond

When it’s tax time,  questions about forgiveness-of-debt income are everywhere.

Questions start when you receive a Form 1099 from a creditor.

But for my bankruptcy clients, the answer is simple:

Debt forgiven in bankruptcy is not taxable.

Tax on cancelled debt

Debt may get cancelled in lots of ways:

• in a short sale;
• by compromising a debt
• by lender compliance with a settlement agreement with the feds;
• in a bankruptcy; or
• in a foreclosure.

Lenders and debt collectors believe themselves bound to send out a 1099 whenever they handle a transaction that may implicate cancellation of debt.   They aren’t rendering an opinion on the tax treatment of the event.  They are just reporting it to the IRS.

Receipt of a 1099 is not the final word on the topic; it’s only notice that the transaction in question has been reported to the IRS.

Cancellation of debt “income”

The standard rule is that debt that is cancelled is treated as though you had received that much cash, and that pseudo-cash is treated as income.  And, if it’s income, the IRS thinks it’s taxable.

The exceptions to recognizing that transaction as income  found in IRC 108 include

• insolvency at the time, and
• discharge of the debt in bankruptcy.

You have to file an IRS form to rebut the 1099.  It’s form 982 and right at the top are the boxes to check to invoke the exceptions.

The form also includes a worksheet to see if you are insolvent for the purposes of this provision of law.

If the 1099 got the facts wrong

Remember, too, that if you did not have personal liability for the debt, the cancellation of that debt is not even forgiven debt.  There was no debt.

You may have no personal liability because of a previous bankruptcy or by reason of California’s anti deficiency laws.

Also, there is special legislation dealing with cancellation of debt upon loss of a primary residence, excluding phantom income from qualifying transactions.

Here’s the IRS on the subject:  http://www.irs.gov/taxtopics/tc431.html

More

Deductions hidden in Chapter 13

File even if you can’t pay

Discharging taxes in bankruptcy

Tax season approaches.

Tax preparers stand a good chance of encountering clients who either have filed bankruptcy, or who may benefit from a bankruptcy filing.

Here’s my list of bankruptcy nuggets that a good tax professional should have at hand.

Debts discharged in bankruptcy don’t trigger cancellation of debt income–

One of bankruptcy’s compelling features is that the debts cancelled by reason of the bankruptcy discharge don’t get included in the debtor’s income.  Bankruptcy, found in Title 11 of the U.S. Code, is the first exception on Form 982 to inclusion of forgiven debt in gross income.

IRS and state tax entities subject to the automatic stay  

A bankruptcy filing enjoins tax authorities from continuing collection action.  Thus the stay terminates garnishments and prohibits levies of the debtor’s assets.  It doesn’t, however, prohibit tax audits.

Bankruptcy can discharge income tax debt three years after return due

Taxes can be wiped out in bankruptcy if the return was due, including extensions, three years  or more before the bankruptcy is filed; any late filed return has been on file for 2 years; and the taxes were assessed more than 240 days before the commencement of the case.  More on overview of taxes in bankruptcy.

Chapter 13 is a quick and certain alternative to an OIC–

A  Chapter 13 plan is confirmed within weeks and binds the IRS just like any other creditor. The case discharges for all time the scheduled taxes, penalties and interest upon plan completion.  The plan must pay the priority taxes (those tied to returns less than three years old) and the interest on the priority tax as of the filing.  No new interest or penalties accrue during the pendency of the case.

Tax penalties are dischargeable

Penalties associated with dischargeable taxes are dischargeable;  all penalties are dischargeable in Chapter 13, and penalties associated with events more than three years past are dischargeable in Chapter 7 even if the tax isn’t dischargeable.

Chapter  7 estate, but not 13 estate, is a separate taxpayer

A bankruptcy estate owes the feds a return, and perhaps tax on capital gains it realizes by reason of sale or foreclosure.   Property remains property of the bankruptcy estate until the estate is closed or the property abandoned.

Tax attributes of the debtor pass to the bankruptcy estate  

The debtor’s basis, loss carry forwards, and exclusions are available to the Chapter 7 trustee, and  unused NOL’s revert to the debtor when the bankruptcy estate closes.

Debtor can elect short tax year for the year bankruptcy is filed  

A short year election can make tax attributes available to the debtor when he files the return for the pre bankruptcy portion of the year.  It can also quantify any tax due in the year of filing so that it is a priority claim for payment from the assets to be distributed in the bankruptcy case.

Tax liens generally survive the bankruptcy case

While lien survive as a charge on the assets the debtor owned at the filing of the case, the lien does not attach to assets the debtor acquires after the case is filed.  In Chapter 13, the lien need be paid only to the extent of the actual value of the assets subject to the lien.

Allowable deductions may be found in payments made on debtor’s behalf by Chapter 13 trustee

Chapter 13 plans often pay over time mortgage interest arrears  on the debtor’s home.  State taxes paid through the plan or business expenses including taxes may be deductions the Chapter 13 debtor can claim.

The rules covering federal taxes in bankruptcy are found in Pub. 902.  State taxes are subject to the same treatment in bankruptcy as federal taxes.

For more

For help with strategic use of bankruptcy to solve tax problems, look for a certified bankruptcy specialist in your community.

Some state bar associations and the American Board of Certification  certify lawyers who are specialists in bankruptcy.  Find California bankruptcy specialists by county.

Image courtesy of Flickr and CharlywKarl