cancellation of debt tax Archives - Northern California Bankruptcy Lawyer

Five Tax Tips For Two Cents

The tax filing deadline approaches.

So why is a bankruptcy lawyer talking about taxes?

I’ve found over three decades as a bankruptcy lawyer that there’s a surprising degree of overlap between bankruptcy and tax .

All too often, it’s tax troubles that brings a family to me for help.

Here’s my two cents on what I know about taxes. It’s not a lot, but what I know is both simple and critical.

File those tax returns

Lots of folks who end up in my office discussing bankruptcy held off filing their returns because they figured they couldn’t pay the tax that would be due.

Bad decision.

Without a return, taxes never die

The IRS will not descend on you the week after you file a return with tax due but no check. They’re still opening envelops.

But filing a return gets all kinds of time periods running that may benefit you: the 3 years til the taxes are dischargeable in bankruptcy; the 10 years til the tax collection statute runs.

Whatever you do, don’t let the IRS file a tax return for you.

Don’t pay tax on discharged debt

If your debts were discharged in bankruptcy last year, that discharge has no tax consequences.

The Internal Revenue Code specifically excludes from taxable income any debts forgiven in bankruptcy.

Cancellation of debt is tax free

You may get a 1099 reporting the cancelled debt. The creditor whose debt is forgiven is required to do so.

It’s up to you to assert that there’s an exception to tax. And there’s an IRS form to rebut any tax consequences. Get it and file it.

Claim deductions for Chapter 13 payments

If you’re in a Chapter 13 that catches up arrearages on real property loans, claim those payments as deductions of your own. Just because the trustee writes the check, it’s still you paying the mortgage interest in that payment.

How to find and claim the deduction

The concept here goes beyond mortgage interest. If the expense was deductible had you written the check, it’s deductible if the trustee pays it.

Get the trustee’s disbursement records in your case from the trustee’s web site and get to deducting.

If you owe tax, fix your withholding

The return to be filed this spring can tell you if you are withholding enough money to pay your taxes.

If there’s a big number on the bottom line of the return for last year, and this year looks similar, increase your withholding now.

What Goldilocks knew about taxes

And if you think you can’t pay taxes as you go and support the rest of your living expenses, you need to look hard at the big picture.

It’s generally a poor decision to short the feds so you can pay AmEx or Visa.

Amend old returns if you missed something

If you missed a deduction or otherwise overpaid your taxes in a previous year, you have only three years to amend that return and claim a refund.

Time running out to claim prior year tax breaks

Lower income families often miss the fact that they get a tax credit (that’s real money, not just a deduction) under the Earned Income Tax Credit. Find out if you are eligible.

Discharging taxes in bankruptcy

The tax filing extension can be dangerous

Wiping out tax liens

Tax Form 1099 Needs A Closer Look: Chances Are It’s Wrong

By Bill Purdy

Tax attorney Bill Purdy says: don’t take IRS form 1099 at face value.

Hundreds of thousands of taxpayers at this moment are looking at, or thinking about, Form 1099-A or Form 1099-C documents they have received.

Some arrived in the tax year a debt was allegedly cancelled.
Others are issued by financial instructions many years after they should have been issued.
Some should never have been issued at all.

Some taxpayers “feel” or outright suspect these 1099 forms must be wrong somehow. Others are dutifully resigned to paying the ordinary income tax that follows the way the form was filled out.

Look again!

At least 50% of the forms issued by financial entities are wrong in one or more respects. Recently, the average number of defective forms coming across my desk is running 75%.

Consult with someone very knowledgeable before OR even after you have filed and/or paid.

Didn’t that debt go away?

Canceled debts can exact a high price at the moment the debt dies, or many years later.

Many people assumed that following the Late Great Financial Unpleasantness, debts dried up and blew away like weeds that died for lack of water.

Some debts actually did die legally speaking. But even dead weeds can choke a garden.

Dead debts, like dead weeds, leave a stubborn root that looks bad on one’s credit record for a long time. That dead root runs deep and often has to be pulled or dug out.

What lenders should do

Lenders are responsible for issuing Form 1099-A and Form 1099-C. They are legally responsible for issuing these forms timely and accurately.

What happens if they don’t do so, you ask?

Absolutely nothing.

Given lenders and financial institutions of all kinds face no consequences if they don’t issue forms with the right information, there seems to be no incentive to get it right.

At least every other form 1099 of this type that I’ve seen in the last 10 years has been wrong in at least one, if not multiple, respects. Worse still, the vast majority of the errors are to the detriment of YOU the recipient/borrower.

Five frequently occurring errors

I hope this article gets readers’ financial juices flowing to the point where they double-check the reality of 1099’s.

Here’s a list of errors deserving of Dishonorable Mention for California taxpayers. While there isn’t time to review these in detail, here’s the gist of each error and the likely effect:

1. California Statutory Purchase Money Debt Cancelled: Under California law, borrowers have no personal liability for loans used to purchase their residence. CCP 580(b). Yet following a foreclosure or a short sale, the 1099 form clearly (AND INCORRECTLY) says the borrower is personally liable for the debt. The cancellation of purchase money debt should trigger no tax. But the form claims otherwise.

2. Debt Discharged in Bankruptcy: Lenders issue tax documents that blissfully ignore fact that debt was discharged during bankruptcy proceeding. In 2019, 1099 forms make no reference to debts discharged in bankruptcy. Thus taxpayers may not know relief from these debts is typically NOT taxable when the relief occurs in a bankruptcy proceeding.

3. Accrued but Unpaid Interest Forgiven: This is an odd exception but a very important one. There is no taxable debt relief to the extent payment of the amount forgiven would have been deductible to you the debtor. IRC Section 108(e).

Interest on home mortgages is the best example of this one. It is Box 2 on Form 1099-A and Box 3 of Form 1099-C. Especially in the case of mortgages that negatively amortized for years, the actual amount of forgiven principal is often far less than what is shown on the form thus reducing the amount of taxable debt relief.

4. Fair Market Value of the Property: Without going into great detail here, this number radically affects whether there is any taxable debt relief and the amount of it (if any). Financial intuitions use a dart boards, Ouija boards, soothsayers, the entrails of an owl, and basically any number they feel like using for the fair market value. Frequently the number supplied is ludicrously inaccurate AND on the low side. This usually increases your taxable debt relief. (Box 4 Form 1099-A Box 7 on Form 1099-C.)

5. The Old “Identifiable Event Ploy”: This is Box 1 on Form 1099-A and 1099-C. It is supposed to have the date that the debt relief actually occurred. It often has the date the creditor gets around to writing the debt off on their books and issuing the Form 1099-A or C.

Look at these instructions from the 2019 Form 1099-C:

“If an identifiable event has occurred but the debt has not actually been discharged, then include any discharged debt in your income in the year that it is actually discharged, unless an exception or exclusion applies to you in that year.”

Yes! That means lenders send out Forms 1099-A and 1099-C when an “event” occurs as far as THEY are concerned, not when debts are actually discharged by operation of law as with foreclosures, bankruptcies, and most California short sales.

This causes ABSOLUTE HAVOC. Many debtors believe they have lost the benefit of statutory exemptions that have now expired but hadn’t when the debt relief actually occurred.

Your to-do list

The rabbit hole goes deeper but please double check with a tax professional you can trust before you pay taxes based on these forms.

If you’ve already paid, explore filing an amended return.

The financial entities who prepared these forms do not give them even a cursory degree of care.

They did the same exact thing a decade ago when they booked millions of loans that should never have been made. Nothing happened to them then, and nothing will now.

It’s up to you.

Guest author Bill Purdy is a tax and real estate lawyer with Simmons and Purdy in Soquel, California. I’m tickled to share Bill’s pointed perspective on this tax problem too many face.

Bill and his partner Pam Simmons are my go-to resource for all matters of tax and mortgage law. Bill assists clients with outstanding federal and state income tax liabilities, Form 1099-A and 1099-C related issues, collection resolution, failure to file returns and employment tax related liabilities.

More from the Soapbox on tax issues

Cathy’s tax tips

Tax deductions hidden in Chapter 13

The secret tax penalty for settling debt

Long Term Tax Savings When You File Bankruptcy Rather Than Settle Debts

By Cathy Moran

Settle your debts outside of bankruptcy and you may be bitten by taxes you didn’t expect years later.

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 gets deducted from the basis of your home. Result: more potentially taxable capital gains on sale.

It works like this.

Tax treatment of cancelled debt

Debt forgiven in bankruptcy or while insolvent gets an exception from the standard tax rule that cancelled debt is taxable as income. IRC 108.

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 capital gain. 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. 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.

How tax exception for forgiven debt works

The ugly truth about debt settlement

How bankruptcy deals with taxes

You've arrived at the Bankruptcy Soapbox, a resource of bankruptcy information and consumer law.

Soapbox is a companion site to Bankruptcy in Brief, where I try to be largely explanatory and even handed (Note I said "try").

Here, I allow myself to tell stories and express strong opinions on how I think law should work for the consumer and small businesses when it comes to debt.

Moran Law Group
Bankruptcy specialists for individuals and small businesses in the San Francisco Bay Area