Settle your debts outside of bankruptcy and you may be bitten by taxes you didn’t expect years later.
Yet, everyone I talk to would rather cut a deal with their creditors than file bankruptcy. It’s universal.
But here’s the killer reason why bankruptcy alone protects homeowners from a unexpected tax consequence down the road.
Debt forgiven outside of bankruptcy may be deducted from the basis of your home. Result: more potentially taxable capital gains on sale.
It works like this.
Debt settlement increases taxes two ways
Debt forgiven in bankruptcy or while insolvent gets an exception from the standard tax rule that cancelled debt is taxable as income. IRC 108. So, if you are insolvent, by the IRS measure, a negotiated settlement doesn’t trigger immediate, taxable income.
But that tax benefit comes with a delayed cost. The amount of the debt forgiven is deducted from the basis of your assets.
So if the tax basis in your home was $200,000 and the debt that was discharged or settled was $200,000, you end up with a house with zero basis.
Sell that house and every dollar you receive is gain, and potentially subject to tax. Ouch!
Special tax rule for homes in bankruptcy
But wait! Wait! There’s an exception to the reduction of basis rule that shields your principal residence from reduction in basis when debt is forgiven.
But that exemption applies only if your debt was cancelled in bankruptcy and you claimed your home as exempt.
So, the basis in your home is not reduced if the debt was forgiven in bankruptcy, rather than an out-of-court settlement, and you claimed an exemption. IRC 1017(c),
So, when you consider your alternatives for getting yourself out of debt, homeowners need to look beyond this year’s tax return to the point at which they may sell their house. Every dollar in basis excludes that dollar from being taxed as capital gain.