How Will Bankruptcy Affect My Taxes?
If you are considering bankruptcy or some other type of debt relief, it is important to think about the tax implications. Choosing bankruptcy instead of a negotiated debt relief option could potentially save you thousands of dollars at tax time.
The basic fact: When creditors voluntarily agree to forgive or reduce your debt, you could owe taxes. If the same debt were discharged through bankruptcy, in most circumstances you would not owe any taxes.
Tax law treats loan forgiveness — where a creditor agrees to reduce or write off your debt — very much as if that creditor had given you the money to pay off the debt. Outside of bankruptcy, you could be required to pay taxes on that “income.” On the other hand, debt discharged through bankruptcy is not treated as income for tax purposes.
Bankruptcy Will Not Affect Your Taxes In Most Cases
Whenever creditors write off debt, they can report it as part of their own federal tax return. To do so, the creditor files a 1099C form declaring the value of the debt — and notifying the IRS that you have received that “income.”
In virtually all cases, debt reduction through bankruptcy — first or second mortgages on your principal residence, secured debt like car loans, medical debt, credit card debt, and others — is not subject to tax.
If you are notified that a creditor filed a 1099C form about a debt that was discharged in your Chapter 7 or Chapter 13 bankruptcy, don’t worry. You can generally file an IRS form 982 to claim a bankruptcy exclusion. There is a similar process for your state tax return.
Other Debt Reduction Options Could Be Taxed
Many people are facing foreclosure because of default on a bank loan, such as an adjustable rate mortgage (ARM). There are many organizations now offering help negotiating with mortgage lenders, but they rarely explain the tax implications of that help. If not handled properly, a negotiated mortgage loan modification or a lender-mediated short sale could create tax liability for you.
The federal mortgage bailout program, which is called the Mortgage Debt Relief Act of 2007, does provide tax relief for people who go through the program to obtain certain types of loan modifications. However, the program is quite complicated and you need to be very careful to comply with the program’s rules in order to qualify for the tax relief. If you do not follow the program to the letter, you could end up owing taxes on any reduction to your mortgage debt.
If you want to avoid paying taxes on debt relief, it is essential to have a lawyer review your situation. Your attorney at Marrs & Terry can explain how any home loan modification you have obtained will affect your taxes.
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Find out specifically how negotiated debt relief and bankruptcy could affect your taxes, then take action to change your financial future. Contact Marrs & Terry online or call us toll-free at 734-663-0555.
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