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NEWSLETTER
April 14, 2010

Taxes, foreclosure and bankruptcy – what’s the connection?

By Bob Reilly/William P. Drew III/ Attorneys at Law

When we were young, April made us think about sunshine and flowers and baseball.

Now we all have taxes on our minds in April. And, taxes can be as confounding as the Cubs not winning the World Series, since one can cost you out of pocket and the other can cost you mental exasperation! Nevertheless ….

if you are facing home foreclosure or considering consumer bankruptcy, you might wonder how today’s decisions will affect your next 1040. There’s a silver lining in those dark clouds: consumer bankruptcy and most home foreclosures of a primary residence do not result in Federal income tax liability.

Taxes and bankruptcy

When it comes to consumer bankruptcy, the answer is simple. There is no tax liability from declaring consumer bankruptcy. Debts are discharged in a Chapter 7 consumer bankruptcy, not “written off” or forgiven, without any choice of the creditor. Federal tax law specifically states that debts discharged in bankruptcy are not income to anyone.

That’s not true of all debt reduction strategies. Some creditors will offer to negotiate a settlement of your debt. They will accept a fraction of what you owe, then close out your account. This seems like a great deal – the harassing phone calls stop and you pay a lot less than the whole debt.

But when a creditor voluntarily settles a debt for less than what is owed, the part that you don’t ever pay is “forgiven” by the creditor. The I.R.S. considers the amount forgiven by a creditor to be income to you. After all, you received money, used it and did not pay it back. The creditor is required to issue an I.R.S. Form 1099-C to you, showing the amount of forgiven debt.

There is a loophole to avoid paying taxes on forgiven debt. If you are insolvent when the creditor settles your debt, you might not owe taxes on all of the forgiven amount. Insolvency means, basically, that your assets are worth less than your debts. This is a complicated concept. You will need the help of a tax professional to figure out whether you are insolvent in the eyes of the I.R.S.

If you are insolvent, you cannot necessarily avoid income tax on all of your forgiven debt. This tax relief is limited to the amount that your debts exceed your assets.

Forgiven debt can result in tax liability, whether you negotiate with the creditor yourself, or hire a debt management company. Before agreeing to a debt reduction plan, or a creditor’s offer of a quick and low-cost settlement, be sure to find out whether you will get a tax form in the mail next April (1099-C) for discharged income, and whether this is in your best interests financially and legally.

Taxes and foreclosure

For now, home foreclosure of your primary residence and the mortgages thereon can be a tax-free event. The Mortgage Foreclosure Debt Relief Act (MFDRA) was passed by Congress in 2007 and then extended through the end of 2012. Under the act, debt that goes unpaid as a result of home foreclosure is excluded from taxable income. This exclusion is limited to $1 million for a single person and $2 million for a married couple. The taxpayer who loses a home in foreclosure also must report the amount of unpaid debt to the I.R.S. when filing a tax return.

Before MFDRA, homeowners who endured the nightmare of a foreclosure often faced more pain from the I.R.S. The debt that went unpaid, as a result of foreclosure, would count as income to the taxpayers who lost their home. Taxes would be due, in a single year, for that “imputed” income.

MFDRA applies to debt from home refinances and to loans that were used to build, remodel or improve a home – often these loans are known as Home Equity Lines of Credit/Loans and Second Mortgages. It does not cover foreclosed mortgages on business property or a house that is not your principal residence (like a vacation condo). Unpaid mortgage debt, if not covered by MFDRA, is treated like a credit card balance that is forgiven by the creditor. Any amount that will go uncollected is seen as income to the borrower. Importantly, if your home equity loan or second mortgage debt was used for purposes other than remodeling and home improvement (e.g., spring training for amateur-want-to-bees in Mesa Arizona or vacations or other such personal sundries that are non-home improvement purposes), then the loan debt will not qualify for the exclusion under MFDRA, but may be otherwise non-taxable if you are insolvent as previously discussed in this newsletter.

Financial problems (and winning the World Series) are hard enough, without the prospect of bigger tax liability. There are ways to survive bankruptcy or foreclosure and still enjoy baseball next April.

Bob Reilly and William Drew are licensed to practice law in Illinois and the Federal courts for the Northern District of Illinois. Bob’s areas of practice include real estate, bankruptcy, estate planning and business litigation.

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