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It’s that time again. Time to explain why filing personal bankruptcy can provide enormous tax savings. Every year, several of our bankruptcy clients contact us in January or February because they have received a 1099-C form filed with the IRS by one of their former creditors. In case you don’t know, debts that are “canceled” or “forgiven” by a creditor may in some cases be treated as though you received that amount as taxable income under IRS rules. While this may seem inherently unfair to the ordinary person who receives a 1099-C—after all, she didn’t actually receive any income—the law can in many circumstances nevertheless treat the benefit she received by not having to pay that “canceled” debt as though it were taxable income.
By far the best protection from 1099-C liability, and the one I want to discuss here, is filing personal bankruptcy. If the reason that a given debt was “canceled” was because it was actually discharged in bankruptcy, then that debt is entirely excluded from one’s income, and there is no tax liability for such discharged debt. This is just one more reason why private debt settlement programs can’t offer the kind of debt relief that bankruptcy can. This is a huge relief to bankruptcy clients who are understandably shocked to receive a 1099-C from their former credit card company, or home equity line lender, or other commercial creditor. Imagine, receiving one of these listing $100,000 plus of debt you know was discharged in your bankruptcy case but now thinking that you might owe taxes on that discharged debt! Fortunately, we can quickly assuage our clients’ fears by explaining that, no, they will not owe any taxes on the debts that were discharged in their bankruptcy.
Unfortunately, it seems, many less well-versed tax preparers seem oblivious to the exclusion of debt discharged in bankruptcy from tax liability. So, even though we are bankruptcy attorneys, we have to put on our tax hats for a moment, and advise our client or former client to direct their tax preparer to IRS Publication 4681, which explains the bankruptcy exclusion for discharged debts along with other exceptions from liability on canceled debt. If the tax preparer knows what she is doing, she will prepare an IRS Form 982 to appropriately claim the exclusion for debts discharged under “Title 11,” which by the way is the Bankruptcy Code. Why the IRS can’t make this more clear for ordinary people by simply referring to the “Bankruptcy Code” on their form is beyond me, but I guess that would be too easy. If the client’s tax preparer is unaware of Form 982, I generally tell them it’s time to find a new tax preparer.
However—and this is really important—for the bankruptcy exclusion to apply, the debt must have been discharged by order of the Bankruptcy Court or by a plan approved by the court. This little pitfall can mean disaster, for example, if a lender on a recourse second mortgage, such as a home equity line, “forgives” or “cancels” the debt prior to the filing of the homeowner’s Chapter 7 or Chapter 13 bankruptcy case. For example, a short sale completed where there is a home equity line prior to bankruptcy may be the worst course of action from a tax perspective. This is yet another reason why it is so critical that if you are facing financial hardship, you should consult with an experienced bankruptcy attorney as early as possible.
There are other exceptions to 1099-C tax liability for sure. For one, the Mortgage Debt Relief Act of 2007 provided that homeowners could exclude from their income debt forgiven on their principal residence through 2012, but that law offered no help for recourse loans on second homes or for other types of debt. In California, most first mortgages even on second homes are treated as non-recourse loans, so they likewise don’t trigger any tax liability post-foreclosure. Additionally, the “insolvency” exception, may also be claimed on Form 982 without having filed a bankruptcy. However, the IRS definition of “insolvency” is substantially different than in bankruptcy because one’s retirement savings in accounts like 401(k)s and IRAs must be included in one’s net worth, while they may be entirely exempted in a bankruptcy case.
The bottom line is that personal bankruptcy filed before a given debt is “canceled” by a lender is the best protection against the IRS treating that canceled debt as though it were income and thus being taxed on it.

In a typical bankruptcy case, you are never going to see a judge.  In a chapter 7, you’re going to see a bankruptcy trustee.  The trustee is a person appointed by the bankruptcy court to administer your case.  The trustee wants to make sure that you are listing all your assets and all your liabilities and you are answering truthful questions to the statement of financial affairs.  The trustee’s job is to see if there are any nonexempt assets that can be taken, sold and administered for the benefit of your creditors.
The only time that you would see a judge is typically if there’s going to be a hearing with regard to whether or not the debt that you reaffirm on, which means the debt that you keep, is going to cause you an undue hardship.  In some cases, judges want to make sure that reaffirmed debts, particularly on vehicles, can be afforded.  If the Schedules I and J show that you as the debtor have a negative disposable income per month, then it is certainly within the court’s discretion to hold a reaffirmation hearing to determine whether or not you have the ability to make that payment going forward.  This is part of the consumer protection portion of the bankruptcy code.  If the judge feels that you do not have the ability to make the payment going forward, he can disregard or disallow the executed reaffirmation agreement between you and your creditor.
That is the only time you would typically see a judge in a chapter 7 bankruptcy case.  The exception to this would be if there is an adversary case filed in your bankruptcy.  An adversary case is a separate lawsuit within the bankruptcy court claiming that a debt that you owe is nondischargeable.  The court would have to make a determination after a hearing or trial based on the evidence in the case and whether or not you are entitled to a discharge of that debt.  Other than that, you would typically not see a judge in a chapter 7 bankruptcy case.
 

Many times licenses are suspended for parking tickets, for child support, for driving without insurance.  These suspensions can be lifted during a Chapter 13 bankruptcy, during the 110 days of your case.  Now, this is not a lot of time to repay the debt; however, it does unfreeze the suspension, give you the opportunity to drive and an opportunity to work out some type of installment payment plan prior to your case coming to a conclusion.
If, after your Chapter 7 case is completed, you don’t have the ability to repay, then you are subject to another suspension.  The best way to stop this is file a Chapter 13.  Chapter 13 basically says that you are going to repay the debt that’s owed due to parking tickets, child support, driving without insurance or some other reason for your suspension, possibly moving violations; over the next 3 to 5 years.  By stretching out over 3 to 5 years, you give yourself a huge cushion of time to repay the debt.  You might want to pay back 100% so that you don’t owe anything after your Chapter 13 is completed or you may wish to do a 10% plan and be subject to the balance due at the end of your case.
In any event, having your driver’s license is very important to reorganize, to get to work, to be able to earn money, to be able to provide for yourself and for your family.  So either Chapter 7 or Chapter 13 is going to provide some sort of relief in other words to get your license back.  If you find that the debt owed based on your license suspension is large, then you might request a Chapter 13 and get a long period of time to repay it back.  There is nothing worse than filing a Chapter 7, undoing a suspension just to see another suspension come on 110 days after filing.  Talk to your attorney about what your rights are and what your obligations are and how either Chapter 7 or Chapter 13 can help you get your license unsuspended.
 

Fannie To Allow Walkaways by On-Time Borrowers: Mortgages – Bloomberg.
Exciting news if you have a Fannie Mae or Freddie Mac insured loan.  With the upcoming changes, you may be able to walk away from a home that is underwater without owing a deficiency to the mortgage company and without going into foreclosure.
This change gives the homeowner the option to deed the property back to the creditor to avoid foreclosure and walk away from the property.  The “deed in lieu of foreclosure” has always been an option but traditionally the mortgage company would try to collect the remaining balance owed on the home from the homeowner.  The change is that now, it appears, they may be writing off the deficiency owed and not trying to collect from the homeowner.  Even more good news is that the government has extended tax-free status to the forgiveness of the loan, however, currently, that law is set to expire at the end of 2013.