How Filing Bankruptcy May Effect Your Income Taxes

Every year at this time the question arises about how filing bankruptcy might effect your income taxes. Depending on the type of bankruptcy you file, the only difference for income tax purposes in filing a Chapter 7, Chapter 11, or a Chapter 13 is in the paperwork.

US taxes as a percent of income in 2008.

US taxes as a percent of income in 2008.

Foreclosure and Bankruptcy Can Have Two Effects on Income Taxes

If a bank forecloses on your property or if you file for bankruptcy protection, the mortgage bank will usually file a 1099C or a 1099A income tax form. Either way, the bank has the right to write off their loss on the debt that ultimately is deficient from what they would have received if the loan had been paid off. This involves the principal on the debt only. For instance, if a bank forecloses on your property and you owe $200,000 in principal, but the bank only gets $100,000 at an auction for the property, they will send you either a 1099C or 1099A for the deficient $100,000. The IRS views this as income.

Filing Bankruptcy Can Protect You Against Income Tax on Deficiencies

Filing for bankruptcy protection can protect you against income taxes that might be charged you on deficiencies of mortgage debt. In a Chapter 7 bankruptcy, whether you keep the property or not, the mortgage debt is discharged in the bankruptcy, unless you sign a reaffirmation agreement. In Chapter 11 and 13 bankruptcy cases, the reorganization of your debts should include catching up on arrears on mortgaged property. If you surrender your property under one of these bankruptcies, the debt will be discharged after the reorganization plan has been completed.

Any discharge of secured debt in bankruptcy will eliminate your responsibility to pay the deficiencies for the secured debt. That means the income taxes due for the deficiencies will also be forgiven. Nevertheless, mortgage banks still have the right to write off their losses on the debt, so you will still get either a 1099C or a 1099A form for income tax purposes.

How to Handle Income Tax on Deficiencies After Filing Bankruptcy

Since there are two forms a mortgage company might send you concerning deficiency, there are two ways to handle the apparent income after filing a bankruptcy:

  1. When a 1099C is sent. A 1099C is a form sent by mortgage banks to show the income you realize as part of the mortgage bank’s write off. All you do here if you have filed a successful bankruptcy and been discharged is to fill out IRS Form 982 with your taxes. This informs the IRS that your deficiency has been discharged in bankruptcy. Fill it out for the tax year of the discharge, follow the directions, and send in with your other tax forms.

  2. When a 1099A is sent. 1099A is related to a capital gains tax. Some banks for whatever reason will send you a 1099A handling the write off as a possible capital gains. A foreclosure can be a transfer of real estate, so banks can do this. If the property in question is your primary residence, you can simply ignore the 1099A if your capital gain is $250,000 filing single or $500,000 filing jointly or less. The only time a 1099A will effect you is if the property is some type of investment property where you actually had a capital gain after the auction of the property. Very unlikely, but if it did occur, you would need to check out IRS publications 544, 551, and 4681.

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