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Five Things You Should Know About Debt, Bankruptcy and Taxes, From an Orange County Debt Settlement Lawyer

February 20, 2009

Many of our clients don't realize that debt settlement or bankruptcy can substantially affect their taxes. With tax season upon us, we thought it was a good time to revisit some basic information on how your debt settlement efforts could affect your income taxes. As always, this is general advice that shouldn't be taken as advice for your specific situation. If you have taxation concerns in a bankruptcy or debt settlement, you should speak with a Southern California bankruptcy attorney to understand your obligations.

  1. If you have filed for bankruptcy, the good news is that most federal income tax (and California income tax) debts can be discharged (erased). In short, you can usually discharge debts for tax returns you filed two or more years ago and debts assessed at least eight months ago -- as long as they don't spring from tax fraud or tax evasion on your part. However, the IRS still has some rights that other creditors don't have, including the right to audit you and assess any unpaid taxes it finds. Furthermore, debts from unfiled returns are not dischargeable, and courts will not grant a bankruptcy without seeing tax returns for the last four years. So if you know you haven't filed a return that you should have, the time to fix that is now.

  2. If you have already filed for bankruptcy, your bankruptcy estate may need to file its own tax return -- separate from yours as an individual. The bankruptcy estates for Chapter 7 filers (and filers of Chapter 11, business reorganization) file their own tax returns; Chapter 13 filers include bankruptcy information in their individual taxes. In either case, this can get complicated. You should talk to your trustee in a Chapter 7 case about which property belongs to you and which belongs to the estate, and consider getting help with your taxes in either kind of bankruptcy.

  3. If you haven't filed for bankruptcy yet but are considering it, you may want to do your taxes first. That's because any tax refund you're owed during a bankruptcy becomes part of the bankruptcy estate. That is, it will be used to pay debts rather than going into your pocket. If you need that money for another purpose, consider filing your taxes and collecting the refund before you start a bankruptcy case. Because this tax return will be submitted to the court, make sure everything is as correct as possible. And if you consistently collect a large tax refund every year, consider getting help adjusting your withholding so that the refund money is available as you earn it, rather than a year-plus later.

  4. If you have a tax lien on your home and it's keeping you from modifying your mortgage loan or selling your home, the IRS has offered you some help. On December 16, the IRS announced that homeowners with a primary tax lien can ask to the agency to subordinate that lien -- make it secondary to a lender's lien. Even better, homeowners can have tax liens discharged if they are selling the home or otherwise giving up ownership for less than the mortgage lien is worth. (People with substantial other assets that the IRS can tap into may also qualify for a tax lien discharge.) This is very important, because it is very difficult to sell or refinance a property with a tax lien that "clouds" the title. With the lien out of the way, homeowners are free to take steps to get out of mortgage debt.

  5. If you've managed to settle your debt without declaring bankruptcy, the bad news is that forgiven debt usually counts as taxable income. This is not true for people who have already declared bankruptcy, people who are provably financially insolvent (whose debts exceed all assets) and people with certain kinds of business debt. Almost everyone else must pay taxes on the portion of the debt that they do not have to pay back. This is complex, and you may qualify for some exceptions, so your best bet is to talk to a tax professional for help.

At Howard Law, we specialize in helping Southern California clients get control of their financial lives, including advising clients on bankruptcy and its potential tax effects. If you're considering declaring bankruptcy and you'd like to learn more about how it could affect your life, we'd like to help. To set up a free evaluation of your case, please contact us online or call 1-800-872-5925 as soon as possible.