Help Clients Reduce Taxes Due on Cancellation of Debt Income

Exceptions to bankruptcy taxation include debt paid as a gift

Taxpayers in the throes of bankruptcy or foreclosure don’t just have the pain of losing their funds or property to worry about—at the end of the day they may also face significant tax burdens, courtesy of the Internal Revenue Code, which can place taxes on the cancellation of debt. There are, however, a number of exceptions to be aware of, plus special reporting requirements which tax pros need to understand as they advise clients.

Many taxpayers don’t stop to consider how bankruptcy and foreclosures can affect taxes, says taxation lawyer Robert E. McKenzie. These burdens affect individuals in all three chapters of bankruptcy—7, 11, and 13. McKenzie offers tips for tax pros helping clients through bankruptcy and foreclosure in his detailed two-hour webinar for Eli Financial, “Cancellation of Debt Income.”

Timing Is Key When Considering Canceled Debt

Individuals who file for bankruptcy still need to file their taxes according to Internal Revenue Service (IRS) Publication 908, “Bankruptcy Tax Guide,” notes tax prep helpers Intuit.

This is where an estate comes in—someone who takes responsibility for paying creditors with non-exempt assets. In Chapter 7, debtors file their 1040 normally while the trustee files a 1041 for the bankruptcy estate. In a Chapter 11, the estate files both the 1040 and 1041.

“In both cases, there has to be two tax returns filed for that current tax year,” Joshua S. Barger, vice president of tax services at Foundation Financial Group, told Intuit. “One will be the Form 1040 (for the individual) and the other will be filed by the trustee, even if the debtor is the trustee, called a Form 1041 (for the bankruptcy estate itself). This is an issue that an individual who is both the trustee and the bankruptcy filer often seems to miss.”

Timing is everything when it comes to determining which debt is canceled, notes The Balance.

“You must include the amount of the debt stated on Form 1099-C on your tax return if the lender filed it with the IRS before you file for bankruptcy,” explained writer William Perez. “It’s not a debt any longer when this happens.”

That money becomes, in effect, income as it’s now borrowed money that does not have to be paid back. The debt is gone if the taxpayer has already received a Form 1099-C.

Advise Clients Correctly on Cancellation of Debt Income

An important part of bankruptcy taxation to be aware of: Section 108 of the Internal Revenue Code excludes from taxable income the discharge of debt, explains Bankruptcy in Brief.

But, as notes, there are some exceptions to that rule:

  • Debt cancelled when the payer was insolvent
  • Debt discharged in bankruptcy
  • Student loans which were forgiven after working a certain period of time
  • Foreign interest that would have been deductible
  • Cancellation of debt as a gift
  • Business real estate or farm exclusions

“If you received a 1099-C form and you qualify for one of these exceptions, you still have to tell the IRS that you don’t have to include the forgiven debt as income and why,” the site explained. “File Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your income tax form, and consider your old debt that much further behind you. For help with the form, review IRS Publication 4681.”

The bottom line, says McKenzie, is that bankruptcy and foreclosure hurt—and ill-informed clients may be in for even more hurt if they are hit with unexpected taxes. That’s where sound counsel on your part can offer some relief.

To join the conference or see a replay, order a DVD or transcript, or read more

Jeff Schmerker

Jeff has extensive professional experience writing on a variety of topics, from pharmaceutical research to environmental history. He has published more than a half-dozen books, and he has worked as a newspaper reporter, magazine editor and restaurant reviewer. He lives in Missoula, Montana with his wife and son.

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