A Denver Debt Settlement Attorney Can Help You Navigate the Tax Implications of Bankruptcy
If you’re in need of debt relief or considering filing for bankruptcy, you may be wondering how this could affect your taxes. Does filing for bankruptcy reduce your taxes? Increase your taxes? And what about tax refunds you’ve received: Can you use that money, or is that going to be wiped away after filing for bankruptcy?
Debt Settlement and Taxes
Debt settlement is when you come to an agreement with a creditor (the person or company to whom money is owed). Let’s say you have $15,000 in credit card debt, and you come to an agreement with the creditor to pay off $8,000 of it and forgive the rest.
While you may think that you’re done with that debt once you pay off the $8,000 you owe, the IRS considers the debt that was forgiven (in this case, $7,000) to be a form of “other income.” Thus, you will be taxed on it.
Of course, the taxes you will pay on that $7,000 are much lower than actually paying $7,000, but it’s still important to prepare.
However, bankruptcy treats these forgiven debts differently.
Bankruptcy and Taxes
Let’s first review the two most common types of personal bankruptcy, Chapter 7 and Chapter 13:
- Chapter 7 bankruptcy erases the majority of your unsecured debts, which include credit card debt, home leases/mortgages, and medical bill debt. You then are not required to pay back what you owe.
- Chapter 13 bankruptcy involves a three- to five-year repayment plan that covers a portion of your unsecured debts, while the rest is discharged. (Note: This is different from a debt settlement repayment plan with a creditor. In the case of Chapter 13 bankruptcy, you are filing for bankruptcy, not simply making an agreement with someone you owe money.)
So when tax time comes, will you owe money on the forgiven debt like you would with a debt settlement? No. If the debt has been forgiven from bankruptcy (as in, you don’t owe it anymore), it is no longer taxable. This, of course, only applies to debts forgiven by the bankruptcy and not future debts. And declaring bankruptcy does not absolve you of owing taxes on income from your job and other sources of income.
Bankruptcy should never be entered into lightly. Bankruptcy affects your finances, your credit score, and your life. That’s why it’s crucial you consult a bankruptcy law firm with years of experience. Wink & Wink are Denver-based bankruptcy attorneys that can help you get back on your feet quickly.
Tax Forms for Debt
If a creditor discharges more than $600 of debt (whether from a debt settlement plan or from you declaring bankruptcy), they are required to send you a 1099-C form, which outlines the amount of money forgiven. Even if they don’t send you one, you are required to report this forgiven debt on Form 982 when filing your annual federal income taxes.
On Form 982, in addition to reporting the total amount of debt forgiven, you’ll need to check box 1a (Discharge of indebtedness in a title 11 case), which lets the IRS know why you shouldn’t be taxed on this forgiven debt which they would otherwise consider other income. (Note: Title 11 refers to bankruptcies.)
You’ll also need to fill out the Part II section of Form 982, Reduction of Tax Attributes. Here you’ll list the basis – the cost of an asset, adjusted by factors such as depreciation – for each asset where the debt was forgiven (example: your house). For anyone – having declared bankruptcy or not – the income tax they owe can be reduced from tax credits, capital losses, or for other reasons. Because someone filing bankruptcy has had debts cancelled, though they won’t be taxed on the forgiven debt, they will forfeit some tax attribute benefits. This section will help you adjust the amount.
What About Tax Refunds?
If you received a tax refund, you might be wondering, Will that go away when filing for bankruptcy? After all, your assets (such as money in the bank) are used to pay off creditors when filing for bankruptcy, so could the tax refund be included in that?
You’ll need to determine whether the tax refund comes from income you earned before or after you filed for bankruptcy.
- If you earned that tax refund in the year before declaring bankruptcy, that money will go to your overall estate that is used to pay back creditors when filing for bankruptcy. For example, in 2021 you file for bankruptcy. A tax refund for the 2020 taxes you pay will go toward paying back creditors in your bankruptcy filing.
- If you earned that tax refund in the year of filing for bankruptcy, the refund based on the income you earned prior to filing bankruptcy will go toward the estate but not the portion of the refund that is based on income you earned after filing for bankruptcy. For example, in 2021 you file for bankruptcy. If you receive a tax refund when you file your 2021 taxes, the portion relevant to the time before you filed for bankruptcy will go toward the bankruptcy.
- If you earned that tax refund in the year after filing for bankruptcy, you keep that money. For example, in 2021 you file for bankruptcy. If you receive a tax refund when you file your 2022 taxes, which are based on 2022 income (as in, after you filed for bankruptcy), you can keep that money.
For the situations where some or all of the tax refund would go toward the bankruptcy, you can possibly keep that money if it’s used for what are considered necessary expenses that you need right now. Examples of these expenses include:
- Medical care
- Car payments
- Mortgage/rent or home repair
As with any bankruptcy laws and stipulations, local rules may be different, so be sure you’re following the rules in your area.
Consult a Colorado Bankruptcy Attorney
Bankruptcy is a challenging decision. That’s why you should consult a bankruptcy attorney with expert knowledge to make sure you don’t make a mistake. Wink & Wink can advise you on whether filing for bankruptcy is the right choice for you, and what steps to take. Call Wink & Wink at 303-410-1720, or contact us online to begin getting help. The consultation is completely free.