Once upon a time the start of tax season was heralded by would-be clients who had been to see me sometimes months earlier calling very excited, because they finally have the money to file. Then, there are the Trustees wanting a share of tax refunds that accrued to debtors prior to the filing of their bankruptcies — those calls are less fun.
Recently, though, tax season has started a bit earlier — in January and early February. Former clients are calling scared, because they have just gotten a 1099 in the mail for some HUGE amount of money that they thought they had discharged in their Bankruptcy — and they are right.
Any time a creditor “forgives” debt, which is a very broad term and doesn’t necessarily have anything to do with whether or not they still intend to collect it or the Debtor still owes it, the creditor is required to send a 1099 for the amount of the forgiven debt to the Debtor and the IRS. The IRS is then going to assume (unless told to the contrary) that this amount is to be included in the debtor’s gross income for that taxable year.
Breathe. I promise, it isn’t nearly this bad. Go back and read that “unless told to the contrary” part again. If you have filed for Bankruptcy and discharged your personal liability for debt, it does not have to be included in your taxable income. There is an IRS form 982 that will solve this problem for you. Form 982 deals with 1099’s if the debt has been discharged in Bankruptcy or if the Debtor was insolvent at the time the debt was forgiven. The insolvency exception is considerably more difficult and more treacherous. The Bankruptcy (Title 11) provision is much more straight forward.
There are different rules if the forgiveness of debt involved your homestead, and the property was foreclosed or the subject of a short sale; but the 1099 may still qualify to be excepted from your taxable income. In that event, I suggest you talk to a competent CPA. Likewise, if you have any questions regarding the application or use of Form 982, a CPA is the person to call.
Where those 1099’s can be a real issue is if you did some type of debt management plan where you paid less than 100% of your debt. If it was a Chapter 13 Bankruptcy, Form 982 may still apply. Otherwise, you might have a real problem; and you cannot call a CPA for help too soon. I hate getting calls from people who tried to do the right thing, tried to pay their debt; and then after years of scrimping and suffering find out after the fact that they now owe tax on the total amount (including interest) that they didn’t pay. A Chapter 13 Bankruptcy would likely have been cheaper, more effective and actually gotten them out of debt instead of into tax debt.
So happy tax refunds, and do not pay tax on discharged debt unnecessarily!