How Does it Affect Form 1040?
For Excel worksheets with formulas go to: www.lisaihm.com User name: lisaihm Password is case sensitive: CODintheREALWORLD This text has been prepared with due diligence. However, the possibility of mechanical or human error does exist and the author accepts no responsibility or liability regarding this material and its use. This text is not intended or written by the practitioner to be used, and cannot be used by a taxpayer or a tax return preparer, for the purpose of avoiding penalties that may be imposed. The text is not intended to address every situation that may arise. Consult additional sources of information, as needed, to determine the solution to tax questions. This publication is designed to provide accurate and authoritative information on the subject of federal tax laws. It is presented with the understanding that the author is not engaged in rendering legal or accounting services Copyright 2017 by, El Cajon, CA and Lisa Ihm, EA, Coronado, CA. Reprinting any part of this text or use without the express written permission of Lisa Ihm is prohibited.
Table of Contents Title 11... 1 Chapter 7... 1 Misconceptions... 1 Debt that is not dischargeable... 2 Income Limitation... 2 Estate... 3 Role of the trustee... 4 Tax attributes transfer into estate... 4 Tax return filing requirement... 4 Reporting dispositions of exempt and abandoned assets... 4 Exempt Assets... 5 Exempt assets not subject to basis reduction... 5 Later foreclosure reported on debtor s individual return... 5 Exempt property s eligibility for bankruptcy exclusion... 6 Abandoned Assets... 6 Later foreclosure reported on debtor s individual return... 6 Reduction of basis usually not required... 6 Suspended passive losses... 6 Abandoned property s eligibility for bankruptcy exclusion... 6 Reaffirming debt... 6 Return of Tax Attributes... 7 Tax attributes transfer into estate... 7 Reduction of tax attributes... 7 Post-bankruptcy NOL cannot be carried back... 7 REMEMBER - No basis reduction to exempt (and usually abandoned) assets... 8 After the... 8 Debtor is left with exempt and abandoned assets... 8 Debtor s reduction of tax attributes... 8 Election to File Short-Year Return... 12 Who CANNOT make the election... 12 How to make election... 12 Should you make the short-year election?... 13 Chapter 13... 14 i
Advantages... 14 Who is eligible... 14 Role of the trustee... 14 Effect on collections... 14 Discharge... 15 Tax Impact... 15 Consider Whether Later May Be Better... 15 Deductibility of Fees to Attorney... 16 ii Comprehensive Example... 17 Worksheet... 22 Appendix... a IRS National Standards: Basic Living Allowance... a IRS National Standards: Health Care... a Local Standards: Transportation... b State Median Income Limits... c
Title 11 1 Be careful when reading the IRS publications regarding bankruptcy. Title 11 is the bankruptcy title. All bankruptcies come under title 11. Under that title there are different chapters, which is where we get the terms Chapter 11 or Chapter 13 Reorganization. Chapter 7 Discharge Chapter 11 Reorganization > $1 million Chapter 12 Farmers and Fishermen Chapter 13 Reorganization < $1 million Chapter 7 Misconceptions Many think you can only file Chapter 7 bankruptcy if you are low income. The truth is that even high-income people can qualify if they have large amounts of debt, especially secured debt. Many think that you lose everything in Chapter 7 bankruptcy. The truth is that most people get rid of their debt and keep their assets. Many think that the bankruptcy court sells all of the debtor s property. The truth is that the bankruptcy court abandons most property and it is returned to the debtor, and then later foreclosed. Who qualifies to file Chapter 7 bankruptcy Although an individual Chapter 7 case usually results in a discharge of debts, the right to a discharge is not absolute. Debtors must meet income limitations and some types of debts are not discharged. Moreover, a bankruptcy discharge does not extinguish a lien on property. 1 1 http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter7.html, downloaded January 9, 2010
Debt that is not dischargeable Some of the common types of debts which are not discharged in a Chapter 7: 2 2 Debts for many taxes Returns for tax years due within 3 years of filing the bankruptcy petition Returns filed within 2 years of filing the petition Taxes assessed within 240 days of filing the petition Trust fund taxes False or fraudulent tax returns or willful attempt to evade or defeat the tax Taxes for which a required return was not filed Debts incurred to pay non-dischargeable taxes (taxes charged on credit cards) Debts that are domestic support obligations Debts for most student loans Debts for most fines, penalties, forfeitures, or criminal restitution obligations Debts for personal injuries or death caused by the debtor s operation of a motor vehicle, vessel, or aircraft while intoxicated Some debts which are not properly listed by the debtor Debts for which the debtor has given up the discharge protections by signing a reaffirmation agreement (if you keep the car you keep the car loan) Debts owed to certain retirement plans, for certain types of loans from these plans Income Limitation Income less than state median - If the debtor's "current monthly income" is less than the state median (chart in appendix), the debtor qualifies for a Chapter 7 bankruptcy. Income more than state median If the debtor s current monthly income is more than the state median, the bankruptcy code requires application of a "means test" to determine whether the debtor has the means to pay off the debt. In determining current monthly income the debtor s income is reduced by: Taxes Payments on secured debts (mortgages and cars) Minimal living expenses (rent, food), same as are allowed by the IRS when they work a collection case Involuntary deductions (union dues, uniforms) Health, disability, or term life insurance Court ordered payments (child support, alimony) Child care Health care Education for employment or disabled child Charitable contributions (if made regularly prior to bankruptcy) Care of elderly, chronically ill, or disabled Special circumstances 2 United States Court Official Form 18, 11 U.S.C. 523(a)
If the debtor has the means to pay at least part of his creditors, a Chapter 7 bankruptcy discharge will not be allowed. (He may be able to file under Chapter 13.) 3 Example Ima Investor Ima Investor owns a rental property o Monthly rental income $3000 o Monthly expenses $3000 Gross wages $240,000/year Net $12,000/month House payment including taxes & insurance - $5000 2 car payments - $1000 each Motor home payment - $1000 per month Allowable basic living expenses - $2000 per month Ima s income is $15,000 per month (rent + wages) and his allowable expenses are $13,000 per month (secured debt payments of 3,000 on rental + 5,000 on house + 2,000 cars + 1,000 motor home + living expenses of 2,000), so he has too much income (he has the means to repay the debt) and would not qualify for a Chapter 7 bankruptcy. However, if there was no tenant in the rental property, the income would drop to $12,000 and his expenses would still be $13,000 and he would qualify! Last 6 months of income and expenses - The means test is calculated based on the last 6 months of income, so a debtor may file for bankruptcy on a specific date to take advantage of a seasonally low income period. That s why we sometimes have a client call and say they are declaring bankruptcy and need their past due tax returns right away. They cannot file unless all required returns have been filed and they may need to file immediately to take advantage of a low income period and pass the means test. Estate Commencement of a Chapter 7 bankruptcy case creates a separate taxable bankruptcy estate that is overseen by a bankruptcy trustee. The estate technically controls all of the debtor's property (including tax attributes) during the duration of the estate. (No physical transfer actually happens, at least at the beginning of the process. The debtor remains in possession of his assets, including his bank accounts, investment portfolio, rental properties, etc. He continues to live in his house and life goes on as usual.)
Role of the trustee When a Chapter 7 petition is filed, an impartial trustee is appointed to administer the case. The trustee s duties include: 1) Determining whether the debtor qualifies for a debt discharge (including whether the debtor passes the means test), and 2) Liquidating the debtor's nonexempt assets if they are free and clear of liens, or if they are worth more than any security interest or lien attached to the property. 3 (If an asset has no equity, the trustee has no use for it.) If all the debtor's assets are exempt or subject to valid liens, the trustee will normally file a "no asset" report with the court and there will be no distribution to unsecured creditors. (Most Chapter 7 cases involving individual debtors are no asset cases.) 4 Tax attributes transfer into estate The debtor s tax attributes transfer into the estate on the 1 st day of the tax year in which the petition for bankruptcy is filed. 4 ONLY TAX ATTRIBUTES THAT EXISTED ON THE DAY OF THE BANKRUPTCY FILING WILL BE REDUCED WHEN THE BANKRUPTCY EXCLUSION IS USED. 5 Tax return filing requirement This bankruptcy estate is a new taxable entity, completely separate from the individual taxpayer. The trustee would file an income tax return on Form 1041 if the estate has gross income that meets or exceeds the amount required for filing. This amount is the total of the personal exemption amount and the basic standard deduction for a married individual filing separately. The trustee normally does NOT file a tax return, because the only income of the estate is COD that is excluded because of the bankruptcy exclusion. However, in order to use tax attributes that may transfer back to the debtor from the estate, the debtor s tax preparer needs the information that would have been on the estate s Form 1041. The preparer may need to recreate the 1041 to determine what amount of tax attributes remain. (This is discussed in detail later.) Reporting dispositions of exempt and abandoned assets Dispositions of exempt and abandoned assets are reported on the debtor s Form 1040, since they are not under the control of the bankruptcy trustee when the dispositions occur. 6 3 11 U.S.C. 701, 704. 4 1398(g) 5 IRC 108(d)(8) 6 Olson, Stanley (1990)
Exempt Assets An individual debtor may protect some property from the claims of creditors because it is exempt under federal bankruptcy law or under the laws of the debtor's home state. 7 In many states, the individual debtor has the option of choosing between a federal package of exemptions or the exemptions available under state law. 8 Typical exempt assets include: 5 Debtor s home (different values are excludable in different states) Cars (basic transportation) (AZ can t exceed $5000 value) Clothes Household furnishings Tools of trade (limited amounts) Limited amounts of jewelry, computers, and electronics Retirement funds including IRAs 9 (IRAs may be capped at $1M in some states 10 ) Specific state exemptions include: Texas and Florida Mansion of any value (CA exempts a max $150,000 home equity) Nevada Gun, home to $550,000, and $1000 wildcard 11 California More than $20,000 wildcard if not using homestead exemption 12 None of these exempt assets ever transfer to the estate. possession of the debtor. They remain in the Exempt assets not subject to basis reduction When doing basis reductions for COD excluded using the bankruptcy exclusion, do not reduce the basis in property that the debtor treats as exempt property. 13 This property was never a part of the bankruptcy estate, so no basis reduction will be applied to these assets. Later foreclosure reported on debtor s individual return Since the exempt property never belonged to the bankruptcy estate, the gain or loss from its sale is reported on the debtor s Form 1040. 14 7 11 U.S.C. 522(b). 8 http://www.bankruptcyca.us/california_bankruptcy_exemptions.html, downloaded January 9, 2010 9 11 U.S.C. Section 522(a)(3)(C) 10 11 U.S.C. 522(n) 11 Nev. Rev. Stat. Ann 21.090(z) 12 http://www.bankruptcyca.us/california_bankruptcy_exemptions.html, downloaded January 9, 2010 13 Code Sec. 1017(c)(1) 14 Olson, Stanley (1990 DC IA) affd (1991, CA8)
Exempt property s eligibility for bankruptcy exclusion Most exempt assets qualify for the bankruptcy exclusion, but in some cases some debts are intentionally not included in the bankruptcy. In order to use the bankruptcy exclusion, the debt had to be discharged by the bankruptcy court, and therefore had to be included in the bankruptcy. If debt that was not included in the petition is later discharged, the resulting COD is not eligible for the Exclusion, because the debt was not cancelled by the bankruptcy court. 6 Abandoned Assets The trustee may abandon any asset that has no equity, and the debt on the abandoned asset is made unenforceable by the bankruptcy court. 15 (In reality, the assets remained with the debtor the entire time and the debtor continued to use them.) Later foreclosure reported on debtor s individual return Since on abandonment the property ceases to be property of the estate, the debtors are taxable on the gain from its sale after abandonment by the trustee. 16 Reduction of basis usually not required No reduction in basis is usually required to abandoned assets because of the basis insolvency rule, which provides that basis reduction is required only to the extent that the debtor s basis exceeds his liabilities immediately after the discharge. This calculation is done by the bankruptcy estate, and since the bankruptcy estate includes all of the secured debt but not the exempt assets it will almost always be basis insolvent and basis reduction will not be required. Suspended passive losses If, before the termination of the bankruptcy estate, the estate transfers an interest in a passive activity or former passive activity to the debtor, that property s unused passive activity loss and credits also transfer back to the debtor and can be used on the debtor s individual tax return. 17 Abandoned property s eligibility for bankruptcy exclusion COD income resulting from the discharge of debt on abandoned property (that is later foreclosed or on which the loan is later modified) does qualify for the Exclusion, because the court made the debt unenforceable. Reaffirming debt If a debtor wishes to keep certain secured property (such as an automobile), he or she may decide to "reaffirm" the debt. A reaffirmation is an agreement between the debtor and the creditor that the debtor will remain liable and will pay all or a portion of the money owed, even though the debt would otherwise be discharged in the bankruptcy. In return, the creditor promises that it will not repossess or take back the automobile or other property so long as the debtor continues to pay the debt. 15 11 USC 554(a) 16 Olson, Stanley (1990) 17 Reg. 1.1398-1(d)(2)
Return of Tax Attributes Tax attributes transfer into estate The debtor s tax attributes transfer into the estate on the 1 st day of the tax year in which the petition for bankruptcy is filed. 18 7 No Form 1041 RECREATE IT The trustee is only required to file a Form 1041 if there is taxable income, and there is rarely any income in a Chapter 7 case since most property has no equity and is abandoned by the bankruptcy trustee. Tax attributes must be reduced, even if the trustee did not file a return. 19 If no Form 1041 was filed, one will have to be recreated in order to determine what tax attributes return to the debtor. Relax, this is much easier than you think! The Form 1041 is actually just a cover page for a Form 1040, and we all know how to do a 1040. Recreate a 1040 for the bankruptcy estate and reduce tax attributes just like you would on an individual return. Any tax attributes not required to be reduced on the Form 982 return to the debtor on the discharge date. Reduction of tax attributes Tax attributes must be reduced by the amount of COD incurred: 1) Within the bankruptcy estate (the discharge of unsecured debt, i.e. credit cards) 2) Excluded from the 1040 (debt secured by real estate) after bankruptcy exclusion ONLY ATTRIBUTES THAT EXISTED AT THE TIME OF THE BANKRUPTCY FILING ARE SUBJECT TO ATTRIBUTE REDUCTION WHEN THE BANKRUPTCY EXCLUSION IS USED. 20 If a net operating loss is created after the bankruptcy petition filing date, that NOL is NOT subject to attribute reduction when the bankruptcy exclusion is used. Post-bankruptcy NOL cannot be carried back An individual debtor cannot carry back to a tax year that preceded the tax year in which the bankruptcy case was commenced any net operating loss (NOL) or credit carryback from a tax year ending after commencement of the bankruptcy case. 21 18 1398(g) 19 Firsdon, Jack (1994) 20 IRC 108(d)(8) 21 IRC 1398(j)(2)(B); IRC 1398(j)(2)(C)(i)
Example Danny Debtor Has a rental property Owes $80,000 of credit card debt No NOL or other tax attributes except basis Chapter 7 bankruptcy in July $80,000 COD excluded by bankruptcy estate Rental abandoned; foreclosed December o $200,000 loss on sale o $300,000 COD (bankruptcy exclusion) o Loss creates NOL on tax return The NOL did not exist at time of bankruptcy filing, so it is not subject to reduction! Danny MUST carry NOL forward. He cannot carry back to a pre-bankruptcy year, so the NOL will carry forward even if no election to forego the carryback period is made. 8 REMEMBER - No basis reduction to exempt (and usually abandoned) assets There is no basis reduction to exempt assets (which were never a part of the estate) 22, or abandoned assets if the bankruptcy estate was basis insolvent. After the Debtor is left with exempt and abandoned assets The debtor can: 1. Continue to make payments on any secured debts on these assets and keep them, 2. Sell them, 3. Quit making payments and the lender will foreclose. Any disposal of the exempt and abandoned assets will be reported on the debtor s 1040, but the bankruptcy exclusion can generally be used to exclude the COD. Debtor s reduction of tax attributes If, after the bankruptcy, a debtor excludes COD on debt that was made unenforceable in a bankruptcy case, they must reduce tax attributes by the excluded amount, BUT ONLY TO ATTRIBUTES THAT EXISTED AT THE TIME OF THE BANKRUPTCY FILING. No basis reduction is required to exempt property, and usually not to property that was abandoned by the bankruptcy trustee (because of the basis insolvency rule), when the bankruptcy exclusion is used. 23 22 IRC 108(d)(8) 23 IRC 1017(c)
Example 1 - Simple No attributes Debtor Debbie has a house, car, furniture, and IRA accounts (all exempt) Owes $80,000 of credit card debt No tax attributes Chapter 7 bankruptcy 9 The bankruptcy estate would have $80,000 of COD income, which it would exclude using the bankruptcy exclusion. The estate is required to reduce tax attributes by the $80,000 that is excluded, but there are no tax attributes to reduce (there isn t even basis in property because all of the property was exempt so none of it is in the bankruptcy estate). There will be no impact on Debbie s personal Form 1040. Any 1099-C for the credit card discharge should be made out to the bankruptcy estate. If Debbie receives a 1099- C in her social security number, put it on line 21 and take it back off again as COD of bankruptcy estate. DO NOT put it on a Form 982. It is not her COD! Example 2 - Rental property Debbie also owns a rental property Mortgage $500,000 Worth $400,000 Suspended passive losses of $40,000 The passive losses go into the bankruptcy estate on the first day of the tax year in which Debbie files her petition. Since the property has no equity, the bankruptcy trustee will abandon it. When he abandons it, he also gives back the passive losses associated with the property. When the bankruptcy is discharged and the $80,000 of credit card debt is discharged, the bankruptcy estate will be required to reduce tax attributes, but it will no longer have the passive losses (they were returned to the taxpayer when the rental property was abandoned), so no attribute reduction will be required. On Debbie s personal Form 1040, even though the trustee had control of the rental property for a few weeks, Debbie actually retained use of the property. She collected rental income during the entire process and will report the rental of the property for the entire year on her Form 1040. Note If the passive losses are in the possession of the bankruptcy estate on the last day of the tax year, the debtor will NOT be able to use them on that year s tax return.
10 Example 3 filed late in the year Debbie files for bankruptcy on December 10 Her hearing date is January 15 of the next year The trustee abandons the rental on January 22 of the next year. Debbie had income from the sale of another rental property before the bankruptcy on March 3 Debbie is not in possession of the passive losses on December 31, so she cannot use them on her tax return (to offset the gain from the March sale of the other property). She will get them back when the rental property is abandoned January 22 of the next year. Example 4 Rental foreclosed later at a gain Rental later foreclosed $100,000 COD Basis $200,000 Foreclosure sale price $400,000 Debbie will report the sale of the rental on her Form 1040. The $200,000 gain ($400k sell price - $200k basis) is taxable. Her passive losses (which are freed up by the total disposition) will offset some of this income. Filing bankruptcy will NOT relieve the debtor from gain on the disposition of the asset, unless the asset is actually sold by the bankruptcy estate (which is rare). The $100k of COD will be excluded using the bankruptcy exclusion. She will have to reduce tax attributes by $100k, but will not have to reduce her passive losses because they are consumed on the tax return in the year of discharge. The reduction of tax attributes occurs on the first day of the tax year following the year of discharge. On January 1 of the next year the suspended passive losses will no longer exist. Her only tax attributes will be basis in her personal use assets, including her house, car, furniture, and IRA (which may have basis if it is a Roth IRA). These were all exempt assets in the bankruptcy, so no basis reduction is required when the bankruptcy exclusion is used.
Example 5 Rental foreclosed later at a loss 11 What if the foreclosure sale price was only $150,000? Filing bankruptcy will not relieve the debtor from reporting gain on disposition of an asset, but it will likewise not eliminate the deductibility of a loss on disposition. The loss of $50,000 would be deducted on Debbie s Form 1040. The $40,000 of suspended passive losses will be freed-up because of the total disposition of the activity. These two large deductions create a NOL on her return. She is required to reduce tax attributes on January 1 of the next year, but the passive losses were used and no longer exist then. The NOL will carry forward (it cannot be carried back to a pre-petition year), but because the NOL did not exist at the time of the bankruptcy filing it is not subject to attribute reduction (it was not a tax attribute transferred into the bankruptcy estate and is therefore not subject to attribute reduction when the bankruptcy exclusion is used.) Example 6 Home foreclosed in later year Home is foreclosed 5 years later COD $150,000 Sales price $350,000 Basis $100,000 The sale is reported on Debbie s Form 1040. The gain on the sale can be excluded using the 121 exclusion. The COD qualifies for the bankruptcy exclusion, even though the home was exempt, since the debt was included in the petition. Example 7 Tax attributes reduced in bankruptcy estate Danny Debtor Filed chapter 7 bankruptcy September 5 $75,000 capital loss carry forward to this year s return $80,000 of credit card debts The bankruptcy estate has $80,000 of COD income. They will use the bankruptcy exclusion to exclude the COD income and must reduce tax attributes. The only tax attribute the estate has is the $75,000 of capital loss carry forwards, so the carry forward is lost. No tax attributes return to Danny when the bankruptcy is discharged.
Example 8 Several types of attributes in estate 12 Danny also had a Net Operating Loss of $50,000 carrying forward to this year Tax attributes are reduced in the same order by the bankruptcy estate as they are by individuals, so the $50,000 NOL is reduced first. Danny also loses $30,000 of the capital loss carry forward, but the remaining $45,000 of capital loss carry forward is returned to Danny for use on his individual Form 1040. Election to File Short-Year Return The debtor/taxpayer can elect to end their tax year the day before the bankruptcy filing. The debtor will file two Form 1040s and the bankruptcy estate will (in theory) file a 1041. Election affects who uses tax attributes; the debtor or the estate. Election not made Attributes transfer to the bankruptcy estate on January 1, so they are not available for the debtor to use. However, any attributes created after January 1 will stay with the debtor, so if large losses or credits are incurred between January 1 and the date of filing, those attributes will stay with the debtor. Election made Attributes transfer on the day of the bankruptcy filing, after being used up by the debtor on the short-year return. If the debtor has income from January 1 to the date of filing, and tax attributes on January 1, filing a short-year return will allow him to use those attributes to offset that income before transferring the remaining attributes into the estate. Election affects who is liable for paying tax liabilities. Election not made If the election is not made, the debtor remains liable for the entire tax liability for the entire year Election made The tax liability from the first short-year return becomes a priority claim of the bankruptcy estate and will be paid first by the bankruptcy estate (if the bankruptcy estate has any assets, which it often does not). If there are not enough assets in the estate to pay the entire tax liability, it transfers back to the debtor. Who CANNOT make the election No short-year election may be made by a debtor who has no assets other than exempt property. 24 (Note that if the debtor has only abandoned property, he can still make the election.) How to make election Make the election by filing Form 1040 for the short period. This return is due on or before the 15 th day of the 4 th full month following the date of the bankruptcy filing. A 6- month extension can be filed on Form 4868, but the extension request must be made timely. Write Section 1398 Election at the top of the Form 4868. 24 IRC Section 1398(d)(2)(C)
13 If the debtor/taxpayer files for bankruptcy on February 7, the short-year return is due Example Due Date if Short-Year Election Made June 15 (4th full month is March, April, May, June, so due 15 th day of that month, June 15). If the taxpayer does not tell you about the bankruptcy until he comes in to get that year s tax return prepared, it may be too late to make the short-year election. Should you make the short-year election? Yes if: Income in the beginning of the year could be offset by attributes, or Income creates a tax balance due in the beginning of the year and there are bankruptcy assets to pay the tax. No if: An NOL, credits, and other tax attributes are created in the period from January 1 until the date of filing. Example 1 Preserve attributes available on 1-1 Danny Debtor declared bankruptcy on September 5 $75,000 capital loss carry forward to this year In May he sold stock and had an $85,000 profit Should he make a short-year election? Yes. If he makes a short year election he can use the capital loss carry forward on the short-year return to offset the $85,000 capital gain. His tax attributes will go into the bankruptcy estate on September 5 (the first day of the tax year that includes the filing date), but the capital loss will already be used up on the tax return for the period from January 1 to September 4. Example 2 No election if no attributes on 1-1 Danny has no tax attributes on January 1 Sold stock in May and had a $50,000 loss Sold more stock in October and had a $50,000 gain Should he make a short-year election? No. If he does not make the election, his tax attributes transfer into the estate on January 1. He did not have the capital loss at that time, so it does not go into the estate and he can use it on his personal tax return to offset the gain from the later stock sale. If he makes the election, the capital loss will transfer into the estate and be subject to attribute reduction.
Example 3 Attributes created during short-year before filing Danny has no tax attributes on January 1 Schedule C business has a $70,000 loss early this year Should he make a short-year election? 14 No. If he does not make the election, his attributes transfer into the estate on January 1. The NOL created by his business loss did not exist at that time so it will not transfer into the estate. If he makes the short-year election the attributes transfer in on September 4. The NOL created on the short-year return would then have to transfer into the bankruptcy estate. (He could carry the NOL back and file for refunds from prior years, but those expected refunds would then become assets of the bankruptcy estate.) Chapter 13 A Chapter 13 bankruptcy is often called a wage earner's plan. It enables individuals with regular income to develop a plan to repay all or part of their debts over three to five years. During this time the law forbids creditors from starting or continuing collection efforts. Advantages A particular advantage of Chapter 13 is that it provides individual debtors with an opportunity to save their homes from foreclosure by allowing them to "catch up" past due payments through a payment plan. 25 Who is eligible Any individual, even if self-employed or operating an unincorporated business, is eligible for Chapter 13 relief as long as the individual's unsecured debts are less than $394,725 and secured debts are less than $1,184,200. 26 Role of the trustee When an individual files a Chapter 13 petition, an impartial trustee is appointed to administer the case. 27 The Chapter 13 trustee both evaluates the case and serves as a disbursing agent, collecting payments from the debtor and making distributions to creditors. 28 Effect on collections Individuals may use a Chapter 13 proceeding to save their home from foreclosure. The automatic stay stops the foreclosure proceeding as soon as the individual files the Chapter 13 petition. The individual may then bring the past-due payments current over a reasonable period of time. The debtor may still lose the home if he or she fails to make the regular mortgage payments that come due after the Chapter 13 filing. 25 http://www.uscourts.gov/bankruptcycourts/bankruptcybasics/chapter7.html, downloaded 1-9-10 26 11 U.S.C. 109(e). 27 11 U.S.C. 1302 28 11 U.S.C. 1302(b).
15 A Chapter 13 debtor is entitled to a discharge upon completion of all payments under Discharge the Chapter 13 plan. The discharge in a Chapter 13 case is somewhat broader than in a Chapter 7 case. Debts dischargeable in a Chapter 13, but not in Chapter 7, include debts for willful and malicious injury to property (as opposed to a person), debts incurred to pay nondischargeable tax obligations, and debts arising from property settlements in divorce or separation proceedings. 29 Tax Impact When a debtor files for reorganization under Chapter 13, no separate bankruptcy estate is created. The taxpayer continues to report all transactions on their individual Form 1040. When the remaining debts are discharged at the end of the case, the COD is reported on the debtor s Form 1040 using the Exclusion, and tax attributes are reduced on the debtor s 1040 return. Example Chapter 13 discharge Wally Wageearner $80,000 credit card debt $20,000 behind on house payments $100,000 2 nd mortgage on house Filed Chapter 13 and made last payment 5 years later Discharged $80,000 of credit cards & $90,000 of 2 nd The $170,000 of COD will be reported on Wally s Form 1040 in the year he makes the last payment. (Until this time the only effect on his personal return will have been that he was not making the full payments on the 2 nd, so his mortgage interest deduction was lower than it was before he declared bankruptcy.) He will use the bankruptcy exclusion to exclude the COD income and is required to reduce tax attributes. There is no separate bankruptcy estate, so all transactions are reported on the Form 1040. Consider Whether Later May Be Better Many COD transactions result in high tax liabilities caused by both taxable COD income and gain on the disposition of property. Before the debtor rushes into bankruptcy to avoid tax on COD income, they should also estimate the tax liability on disposition of the property. It may be better to wait and declare bankruptcy 3 years later to discharge the tax on disposition. (A later bankruptcy is generally only beneficial if the debtor is not keeping any properties. If the debtor retains property, the IRS will file a tax lien on that property as soon as they realize the large amount of the liability, and a later bankruptcy will not remove the tax lien.) 29 11 U.S.C. 1328(a).
Deductibility of Fees to Attorney 16 The debtor can deduct fees in connection with a bankruptcy if the bankruptcy is proximately caused by the failure of a business enterprise. The deductible portion is the part of the total fee which bares the same ratio to the legal fee as the claims of the business creditors bears to the claims of all the creditors. 30 Business debt x Total legal fee = Deductible legal fee Total debt 30 Pierson (1986); Cox (1981); Catalano (2000)
Comprehensive Example 17 Ken and Barbie declared bankruptcy February 1 Pertinent pages from petition follow Discharged August 1 Usedtobehome Drive mortgage modified Dec 1 of the same year Dreamhouse Lane foreclosed December 5 of the same year Boughtlongago Way foreclosed January 1 of the next year Paid attorney s fees of $3,000
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Worksheet 22
Solution 23 Short-year election No short-year election was made because the taxpayer didn t tell us about the bankruptcy until after the deadline had already passed. A short-year election would have allowed us to use the NOL to offset income earned between January 1 and the bankruptcy filing date. Passive losses - The passive losses return to the debtor when the property is abandoned by the trustee. Since the property and associated passive loss was abandoned before the end of the tax year, they are back in the possession of the debtor in time to be used on his Form 1040. Net Operating Loss The California NOL is larger than the federal NOL because CA does not allow NOL carrybacks. Reduction of Tax Attributes There is $18,000 of COD in the bankruptcy estate, so tax attributes must be reduced by that amount. Attributes returned to debtor The remaining NOL is returned to the debtor on the date the bankruptcy is discharged. Since the bankruptcy was discharged before the end of the year, they are back in the possession of the debtor in time to be used on the debtor s Form 1040. (If the bankruptcy had not been discharged until the next year, the NOLs would not be available for use on the current year 1040, but could be used on the next year s return.) Attorney s fees The $3000 attorney s fees must be prorated among the debt that was discharged. Debt Description Amount % x fee Deductible Where Credit cards $ 18,000 <.5% No Dreamhouse Lane 4,000,000 70% x 3000 No Boughtlongago Way 1,250,000 22% x 3000 $660 Sch E Usedtobehome Drive 450,000 8% x 3000 No Total 5,718,000 100% Note: Ken and Barbie moved back into Usedtobehome Drive before the bankruptcy filing, so it had reverted to personal use property.
Example Continued Usedtobehome Drive loan modified December 1 Bank discharged $70,000 of accrued interest and $100,000 of principal 24 The accrued interest that is discharged does not create COD, because the interest would have been deductible if paid. Therefore, the COD is $100,000 (regardless of what the 1099-C says). Regardless of whether the loan is recourse or nonrecourse, the reduction in the principal amount by a loan modification creates COD. On Ken and Barbie s Form 1040, the COD is excluded using the bankruptcy exclusion since the debt was made unenforceable by the bankruptcy estate. They must reduce tax attributes on Jan 1 of the next year, but first we need to complete this year s return. Example Continued Dreamhouse Lane foreclosed December 5 Note the date on 1099-A (They mistakenly believed that when they filed for bankruptcy the house would be taken from them immediately, so they abandoned Dreamhouse and moved back into Usedtobehome Drive. They could have stayed in Dreamhouse for almost a whole additional year!) When refinanced, $100,000 of costs added to mortgage balance Real estate taxes due $50,000 Accrued interest estimated to be $200,000 Sale price on trustee s deed $1,500,000 Unpaid debt together with costs on trustee s deed $4,270,000 Purchased for 4,200,000 NOTE: This form was completed incorrectly. Box 2 should have been $4,000,000 (but incorrect forms are common and we need to understand how to calculate the correct numbers).
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26 The COD is excluded using the bankruptcy exclusion rather than the Qualified Principal The loss on the sale of the residence is not deductible. Residence Exclusion (bankruptcy exclusion is mandatory). Attribute reduction is required, but we need to complete the entire return for this year before we can determine which attributes will be reduced. Example cont. After completion of the current year return, these attributes remain: NOL $35,000 ($72k returned by bankruptcy estate - $37k used) Passive loss carryover $20,900 on Boughtlongago Way
27 Basis reduction is not required in exempt assets and the bankruptcy estate was basis insolvent (debt exceeded basis immediately after discharge) so no basis reduction is required. Ken and Barbie lose all of their NOL and passive losses.
28 Ken and Barbie lose all of their CA NOL and passive losses.
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FOR CALIFORNIA PURPOSES ONLY 30
Example Continued Boughtlongago Way foreclosed January 5 of the next year Property located in Arizona, recourse loan $400,000 sale price per trustee s deed Land basis $10,000, building basis $0 Unpaid debt together with costs from trustee s deed $900,000 Unpaid real estate taxes $3,000 Foreclosure costs $7,000 Accrued interest due $90,000 31
32 The gain on the sale will be reported on Ken and Barbie s Form 1040. Declaring bankruptcy will not alleviate tax on gain from the disposition of property unless the property is actually sold by the bankruptcy estate (which is extremely rare). The suspended passive loss on the property was lost to attribute reduction. (The gain on the sale is passive, so if there were any suspended passive losses on other properties, those losses would be available to offset the gain.) Planning Opportunity What if Boughtlongago Way had been foreclosed in the same year as the bankruptcy discharge? The $35,000 federal NOL and $112,000 California NOL that were lost to attribute reduction could have been used to offset the gain on the sale, as well as the $20,900 passive losses that were lost to attribute reduction. The best tax outcome will usually result if all properties are foreclosed in the same year. Planning Opportunity Should they have waited to declare bankruptcy? If they had let the properties go to foreclosure, filed the tax returns, and waited 3 years before declaring bankruptcy, the amount of tax would have been higher because the COD would not have qualified for the bankruptcy exclusion, but they could have had the entire tax discharged in the bankruptcy. The strategy works best when the debtors are not going to keep any real estate, because the IRS will file a Notice of Federal Tax Lien as soon as the balance due returns are filed. In this case, they are not keeping any real estate, so the Tax Lien would not have anything to attach to.
Appendix a IRS National Standards: Basic Living Allowance 31 IRS National Standards: Health Care 31 Current allowances are available at http://www.irs.gov/businesses/small-businesses-&-self- Employed/National-Standards-Food-Clothing-and-Other-Items
Local Standards: Transportation 32 b 32 Current allowances are available at http://www.irs.gov/businesses/small-businesses-&-self- Employed/Local-Standards-Transportation
State Median Income Limits 33 c 33 For cases filed after 4-1-2016 Chart changes about every 18 months